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THE EDUCATION SECTION Every month we look at a particular financial topic in a little more detail. This month it is APR (Annual Percentage Rate)____________________________What is it?In simple terms, the APR (Annual Percentage Rate) is a measure of how much a given loan or mortgage will cost you in interest & charges per calendar year (based on the full term of the loan). The figure for the APR takes into account all of the normal costs associated with the loan, such as-•arrangement fees•interest charges•any annual charges (which may be the case with credit cards)•any other such costs - so as to provide a clear, overall figure for the total cost of the loan. This makes it possible to compare one APR with another. The cheaper the APR, the cheaper loan. But comparing APRs with other types of rates is not entirely straightforward.When not to use APR. Comparing an APR on a mortgage is a fairly pointless comparison, as this will compare the rate over the full term of the mortgage, when most people only hold their mortgage throughout the special deal period, before remortgaging or negotiating another new deal. In this instance a much more accurate method of comparison is a 'true cost comparison' over the period of the deal. This takes into account the monthly payments expected within the deal period and any set up costs incurred to purchase the deal, such as arrangement and valuation fees, etc. As a Company, this is our preferred, and we believe a more accurate, route for comparing mortgages for our clients.Comparing rates.Let's look at an example of why an APR rate is usually much cheaper than an apparently similar fixed or flat rate.Supposeyouarelookingfora6yearloanof£1,000.Oneloanquotesyouaflatrateof5%,andtheotheranAPRof 6%. Car dealers often do this, and quote a 'flat' rate. Which is cheaper?In fact, you can't compare these numbers. They may look very similar at first, but are actually very different.Depending on the exact calculation, an APR of 6% will usually be much cheaper than a flat rate of 5%. This is because:•the flat rate is applied to the whole of the loan every year •theAPRiscalculatedontheamountoutstanding,whichisreducingeachyear.Asyouarepayingtheloanbackon a regular basis, the interest payment you make reduces. Click here to see an example of the figuresCalculating APRThemathsforcalculatingAPRisnotentirelystraightforward(eventhoughitsoundsasthoughitoughttobe), especiallywhenaloanhasbeenadjustedtoprovidefixedmonthlypayments.Asyoucanseefromtheillustrative tables, the interest rate appears to change each month, so there's no way you can work out the APR in your head.What you can do with the above example, though, is work out the equivalent flat rate. •You pay £210 in interest on a capital of £1,000 - i.e. 21% over 6 years•The equivalent yearly interest rate is 21%/6 = 3.5%•That is, each year you pay back an additional 3.5% of the amount you borrowed in interest•By the end of loan you have paid 21%YoucanseethatourAPRof6%hasanannualequivalentof3.5%flatrate,andthereforeisindeedmuchcheaperthan a flat rate of 5% quoted for our 'fixed' example on the pop out screen. Finally, as always, do not hesitate to contact us if you would like further details or information.
The table below shows, approximately, the interest payments you would make using the 2 different calculations. (note: this is just the total INTEREST for each year. Your monthly payments would also include an amount to pay back the capital (£1,000/6 years = £166.67 per year or £13.89 per month)YearFixedAPR1£50£602£50£503£50£404£50£305£50£206£50£10Total£300£210The above table is to illustrate the principle only; the calculations are not accurate and the actual amount payable using an APR of 6% would actually be much less than £210.Nevertheless, you can see that the 'Fixed' calculation does exactly what it says: the interest is fixed for each year.However, with the APR calculation the interest changes each year. It is worked out as a percentage of the amount you still owe. After the end of the first year you have paid some of the loan back, say approximately £140, so your loan has been reduced to £860. The new interest calculation is therefore 6% of £860. Each year the amount of money you owe reduces, so you pay less and less interest.Fixed monthly paymentsHowever, you may wonder, in view of the explanation immediately above, why your monthly repayments usually don't reduce when interest is calculated using APR. This is because it is standard practice for lenders to keep your regular payments fixed, so that you can budget a regular amount and not have to pay more in the early years.IMPORTANT NOTEThe lender does this with a clever calculation when working out how much of the loan you repay: the lender increases the amount you repay (of the capital) as you go through the loan. This compensates for your reducing interest rates. In the above example, your total monthly repayments, including interest and loan repayment, would be £210.66. This is exactly the same principle with a Capital & Interest mortgage. Although the overall total stays the same, in later years your loan repayment increases whilst the interest payment reduces, as shown below:YearRepaymentAPR InterestTotal paid1£141.66£60£201.662£151.66£50£201.663£161.66£40£201.664£171.66£30£201.665£181.66£20£201.666£191.66£10£201.66Total£1,000.00£210£1,210.00But remember, this is just an 'accounting convenience' - it doesn't change what you pay back overall, and it doesn't change the APR.
Remember, this is for traditional loans - credit cards do not work like this - the interest is calculated on what you owe each month, and providing you pay off more than the interest each month, the amount you owe will decrease and so will your payments. WATCH OUT for credit cards where the minimum monthly payment is not enough to cover the interest; in this case the amount you owe will increase each month.