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Understanding APR

Understanding APR


All loans involve interest. Here's how it works.


by Gary Foreman

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Everyone is concerned about interest rates these days. Here’s a quick explanation of an important aspect of them: the annual percentage rate.

Definition of APR
Simply put, APR a rate that the borrower pays for using the lender's money. Interest is typically stated in a percent of the amount owed that's due every year of the loan.

An easy-to-grasp example would be if I borrowed $100 from you and agreed to pay you back one year from today along with 8% interest. When the year was up I'd need to give you $108 (the original $100 plus $8 interest).

Compounding Need Not Confound
The frequency of compounding effects the real cost of borrowing. In our example, the interest was compounded once a year. But what would happen if we compounded it twice a year? At the end of the year I would need to pay you $108.16.

Why sixteen cents more than the original example? I'd still have to pay back the same $100 principal. But because the interest is compounded twice each year, we'd need to calculate and add two separate interest payments. For the first six months I'd owe $4 ($100 principal times 8% annual interest divided by two - i.e. 4%).

But for the next six months I'd owe $4.16. Because interest was owed (and unpaid) after the first six months, the principal amount was increased by $4 to $104. And 4% (half of 8%) of $104 is $4.16. So over the entire year I'd owe $8.16 for interest ($4 first six months plus $4.16 for the second six months).

If we were to compound daily, the total due at the end of a year would be $108.33. So even though the interest rate stays the same (8%) the amount that you'll pay could vary by $0.33 depending on how often interest is compounded. Not a tremendous amount, but it does add up when you're borrowing hundreds of thousands of dollars.

The APR will include any additional costs caused by frequent compounding. When it's used in a mortgage situation it also includes mortgage insurance and any “points” that came with the mortgage. For most of us it's almost impossible to calculate how much we'd owe on a mortgage with all the different variables involved. The APR does that for us. We can take two mortgages and compare the APR on each. You can also use the APR to compare non-mortgage consumer loans.

Paying it Down
A traditional 30-year mortgage earns a lot of interest for the lender. To illustrate, we turned to a mortgage calculator on bankrate.com. For a 30-year, $200,000 mortgage at 6%, you'll pay $231,676 in interest over the life of the mortgage — more in interest than you originally borrowed.

A 15-year mortgage (the same $200,000 at 6%) would require $103,788 in interest payments. That's a huge difference. The downside is that you will need to handle a higher monthly payment ($1,687 vs. $1,199).

As long as your mortgage allows for prepayments, you can pay more than the regular amount each month. Have the lender apply the extra money to a reduction in principal. Depending on how much you prepay each month, it could be just a effective as a 15-year mortgage in reducing the amount of interest paid.

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Gary Foreman is a former financial planner who currently edits The Dollar Stretcher.com website and newsletters.

 



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