We all know the interest rate on a loan is the cost to borrow money. Although at CariDollarsAndSense we believe Financial Freedom is achieved more rapidly if you avoid most debt, if you must borrow, then try to get the lowest interest rate possible. Unfortunately, determining the lowest rate is often not straightforward. The purpose of this post is to help you understand the problems involved, so you can keep more of your money (pay less interest).
Don’t worry, we do not intend to get into detailed arithmetic (some calculations could be complex). To illustrate the points, we’ll use a few simple examples that should be sufficient to allow you to make an informed decision. For those interested, the Tools section includes a spreadsheet (APR Examples) with the examples used.
Firstly, please do not just accept whatever your preferred lender offers you. Your opening response should be to politely insist they do better. Getting a better deal is always possible, but you need to be prepared for the conversation.
Do not make a lending decision in haste; take your time and shop around. Unless your preferred lender knows you are informed and ready to use another lender, they are not really motivated to improve their offer. But if you work hard to save more of your money, they’ll get motivated very quickly to keep your business.
Problem #1: The way rates are quoted
Let’s say you have to borrow $10,000 and you are told the interest rate is 10%. You’ll probably interpret this to mean: if you repaid the loan at the end of one year, you’ll owe interest of $10,000 x 10% = $1,000.
If you repaid it after two years, then you’ll owe $10,000 x 10% x 2 years = $2,000.
If you repaid at the end of six months, then you’ll owe $10,000 x 10% x 6/12 = $500.
Nothing above is probably a surprise, because most of us think of interest rates on a whole-year basis (or annualized). A problem arises, however, when rates are quoted on a different basis e.g. monthly or quarterly. The same 10%, could be quoted as (10%/12) 0.83% monthly or (10% x 3/12) 2.5% quarterly.
When a rate is not annualized, you have to mentally convert it to a whole-year rate in order to understand and compare it to other quotes.
Problem #2: Add-on loans versus simple interest
The interest rate quoted sometimes depends on how interest is treated in your loan, meaning add-on or simple interest.
An add-on loan means the interest over the life of the loan is calculated and added to the principal. Principal plus interest is then divided by the number of months to arrive at your loan instalment.
A $10,000 loan for 2 years at 10% will mean, $2,000 total interest; consequently, your monthly instalment is ($10,000 + $2,000 =) $12,000 / 24 = $500.00.
A simple interest loan is different because interest is not calculated in advance but instead, at each payment date, you pay interest based on the loan’s balance for the number of days it was outstanding. When your principal declines, you pay less interest, although you are paying the same rate (10%). Mortgages for example are simple interest loans (but these are also referred to as amortizing or reducing balance).
If you use our Cari$ Loan Calculators, you’ll see the monthly loan payment for a $10,000 amortizing loan for 2 years at 10% will be $461.45.
Problem #3: Fees, closing costs, etc.
Whenever you borrow, it’s a fair bet you will be charged a fee of some sort, but strangely, most borrowers seem to ignore it.
A $10,000 loan for one year at 10% will cost you $1,000 in interest. But if you were charged a fee (application, origination, administration, etc.) of $100, then the real loan cost is ($1000 + $100 =) $1,100. A simple calculation $1,100 / $10,000 shows the loan costs 11% and not the 10% you were quoted.
Problem #4: Interest added to your loan balance
If you are charged interest and it is unpaid, it could be added to your loan balance. In this case, the next time interest is charged, it is calculated on the new (higher) loan balance.
Let’s say you have a loan for $10,000 for one year at 10%, which you pay at maturity, but interest is charged every 6 months. Therefore, at the end of 6 months you are charged interest of $10,000 x 10% x 6/12 = $500. For the next six months, you are charged ($10,000 + $500 =) $10,500 x 10% x 6/12 = $525.00 i.e. total interest for the year of $1,025.00. Whereas, interest charged and paid at the end of the year would be $10,000 x 10% = $1,000.00.
This treatment is referred as “compounding”, and the real interest cost is 10.25% and not the 10% quoted.
The solution: APR
The solution to these problems is to use the loan’s APR or “Annual Percentage Rate”.
The nominal APR is simply the annual cost of borrowing money. It eliminates the confusion of monthly and quarterly rates by using an annualized basis, which is how most of us think of interest rates – what is the rate if I had the loan for a whole year.
While the nominal APR is ok for a quick look, it is NOT the true cost of borrowing. For this, you need the effective APR because it includes fees charged and takes into account compounding.
Let’s say your credit card interest rate is 2% a month. This is not helpful because we do not think about interest rates on a monthly basis; therefore the nominal APR is more useful: (2% x 12 months =) 24%.
But, this is NOT the true cost because if you carry a balance and do not pay it off, interest is compounded monthly (probably even daily). You, therefore, need the effective APR, which is 26.82%. When you add in fees, it will be higher.
Let’s go back to Example 1. If you relied only on the quoted interest rate, you could easily end up taking the add-on loan. But now you know the APR is nearly 20% compared to 10% for an amortizing loan, so you can save ($500.00 – $461.45 =) $38.55 per month or $925.20 over two years. That’s quite a lot!
Benefits of using APR
In summary, the effective APR is the ONLY way:
- You know the true loan cost. Interest charges erode your wealth; therefore, try hard to obtain the lowest rate possible. Do not expect a lender to automatically do this for you.
- You can easily compare loan costs among lenders to identify the cheapest offer (the lowest APR).
Points to note
If you are planning to borrow, make sure and ask what is the loan’s effective APR. If they are unable to answer, then ask: (a) What fees do I have to pay? (b) When is interest charged and when do I pay it? and (c) Is interest ever added to the loan balance?
Just Google “APR calculator”. Many are available online.
Before wrapping up, let’s emphasize a couple points:
- The APR is a valuable tool to compare loan costs when you are trying to decide which lender has the best deal.
- The APR would change in the future if the loan is variable rate.
- Your actual interest cost could vary from the initial APR if additional fees or other costs are added to the loan later. This is especially the case with credit cards because myriad fees could be charged depending on your payment behaviour.
We hope you enjoyed the post and now understand how to evaluate the true cost of a loan and why it is so important.
If you have questions or thoughts to share, we’d love to hear from you in the comments below!