APR: Pay Attention to This Number Before You Finance Anything
Far too often, people decide to borrow money based only on the amount of the monthly payment. Have you ever done this? You look at the monthly payment for a car, for example, and decide to apply only if you can afford to pay that amount of money each month.
Even if you can comfortably afford the monthly payment, that’s not the most important number to look at when you’re borrowing money. You should actually pay attention to the APR when you finance ANYTHING.
What Is the APR?
APR stands for annual percentage rate. This number is a percentage and represents the annual cost of borrowing money. When people say interest rate, they’re often referring to the annual percentage rate.
Looking at the APR is the best way to understand how much it’s actually costing you to borrow money. The higher the APR, the more it costs you to borrow money, especially over a long period of time.
Sometimes you may pay a small fee and repay the money back quickly and it doesn’t seem like you’re paying a lot to borrow the money, but the calculated APR may be extremely high.
Here are some examples of APRs to give you some perspective:
- A $100 two-week payday loan with a $15 fee has an APR of almost 400%
- A $24 overdraft with a $34 fee that you repay in 3 days has an APR of 17,000%
- The national average credit card APR is 17.03%
- The average credit card APR for bad credit is 24.18%
Notice that with payday loans and overdrafts, the fee is small, but the APR is extremely high. This is how short-term lending traps people into a cycle of borrowing money. It doesn’t seem like a lot of money, but when you consider the amount you’re actually borrowing, it is a lot of money and it gets very expensive over time.
APR Is More Important Than the Monthly Payment
Of course, you should be sure you can afford the monthly payments on whatever you’re financing. Taking on monthly payments you really can’t afford can lead to bigger problems, like missed payments and damaged credit.
Even when you can afford the monthly payments, if the APR is high, then you’re paying more than what’s necessary.
For example, if you borrow $10,000 at 7% APR for 5 years, your monthly payment would be $198.01. Not too bad. You’d pay $1,880 in interest.
On other hand, if you borrow $10,000 at 5% APR for 3 years, your monthly payments would be higher – almost $300, but you would only pay $789 in interest.
You gain nothing by paying more interest. In fact, the interest you pay is money that could have been put towards something else like paying down debt, building your emergency fund, or investing in a retirement account. Interest goes straight into the lender’s pockets. One of the reasons big banks are billion dollar businesses is because many people focus on the monthly payment instead of the interest rate.
How Do You Know the APR?
The Truth in Lending Act is a Federal law that requires lenders to disclose the APR whenever you’re borrowing money. Always look for the APR in the disclosures so you know whether you’re paying too much to borrow money. If you can’t find the APR, ask the lender.
You can get a lower interest rate by negotiating and shopping around with various lenders and credit card companies. Improving your credit score can also help you qualify for a lower APR. The higher your credit score is, the lower your APR will be. This is one of the reasons it’s so important to work on your credit score before you borrow money, especially with mortgage or car loan.
Make sure you also know whether the APR is fixed or variable. A fixed APR will stay the same for the entire time you have the loan. This means your monthly payment and interest paid will remain the same. Variable APRs change periodically. They may change on a set schedule or whenever the Federal Reserve changes the interest rate it charges to banks (the federal funds rate). If you hear news that the Fed is going to raise interest rates, that means your current interest rates will likely change shortly after.