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Annual percentage rates
It is an expression of the effective interest rate that will be paid on a loan, taking into account one-time fees and standardizing the way the rate is expressed.
The aim of using APR is to calculate a total cost of borrowing. APR is intended to make it easier to compare lenders and loan options.
The APR is likely to differ from the "note rate" or "headline rate" advertised by the lender.
While there are several acceptable ways to calculate the exact APR, the general process is:
Total the included one-time costs and add them to the face amount on the loan
Calculate a monthly payment for that amount at the loan's "note rate"
Calculate what interest rate would have to be applied to just the face amount of the loan in order to equal the calculated monthly payment in step 2.
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In a simplified example, if you borrow $100 for one year at 5% interest (so that you will owe $105 at the end of the year) and you pay the lender a $5 origination fee, your total cost to borrow the money will be $10 ($5 in a year for interest plus $5 now for the origination fee). Your APR will come out at just less than 10%.
In the US and the UK, lenders are required to disclose the APR before the loan (or credit application) is finalized.
An effective annual interest rate of 10% can also be expressed in several ways:
0.7974% effective monthly interest rate
9.569% annual interest rate compounded monthly
9.091% annual rate in advance.
These rates are all equivalent, but to a consumer who is not trained in the mathematics of finance, this can be confusing. APR helps to standardize how interest rates are compared, so that a 10% loan is not made to look cheaper by calling it a loan at "9.1% annually in advance".
APR often does not represent the total cost of borrowing.
Some classes of fees are deliberately not included in the calculation. Because these fees are not included, some consumer advocates claim that the APR does not represent the total cost of borrowing. Excluded fees may include:
routine one-time fees which are paid to someone other than the lender (such as a real estate attorney's fee)
penalties such as late fees or service reinstatement fees without regard for the size of the penalty or the likelihood that it will be imposed.
Lenders argue that the real estate attorney's fee is an example of a pass-through cost, not a cost of the lending. In effect, they are arguing that the attorney's fee is a separate transaction and not a cost of lending. This is true if the attorneys fees are the same everywhere, or if the customer is free to select which attorney is used. If the lender insists on using a specific attorney however, then the cost should be looked at as a component of the total cost of doing business with that lender. This area is made more complicated due to the practice of the lender receiving money from the attorney and other agents to be the one used by the lender. Because of this, in the United States, the government has made all lenders produce an affiliated business disclosure form, which shows the amount paid by the lender to things like appraisal firms and attorneys.
Lenders argue that including late fees and other conditional charges would require them to make assumptions about the consumer's behavior—assumptions which would bias the resulting calculation and create more confusion than clarity.
APR is dependent on the loan period.
In addition to the difficulties of determining what fees to include or exclude, annual percentage rate is dependent on the time period for which the loan is calculated. That is, the APR for one loan with a 30 year duration loan cannot be compared to the anual percntage rates for another loan with a 20 year loan duration. APR can be used to show the relative impact of different payment schedules (such as balloon payments or bi-weekly payments instead of straight monthly payments), but most standard APR calculators have difficulty with those calculations.
Furthermore, most APR calculators assume that an individual will keep a particular loan until it is completely paid off resulting in the up-front fixed closing costs being amortized over the full term of the loan. If the consumer pays the loan off early, the effective interest rate achieved will be significantly higher than the APR initially calculated. This is especially problematic for mortgage loans where typical loan durations are 15 or 30 years but where many borrowers move or refinance before the loan period runs out.
In theory, this factor should should not affect any individual consumer's ability to compare the APR of the same product (same duration loan) across vendors. ARP may not, however, be particularly helpful when attempting to compare different products.
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article "Annual Percentage Rate".