
There
are three things to look at when you take out a loan.
Each one affects how much you pay for the loan:

The
length or term of the loan

The
interest
rate

The
annual
percentage rate
LENGTH
OF THE LOAN
The
length of the loan is the easiest part to understand.
The shorter the length of the loan, the quicker
you’ll pay it off, and the less interest you will be
charged. However,
the shorter the term, the bigger your payments.
Here’s
an example of monthly payments on a loan for $5,000 at 5%
interest:
Term

#
of Payments

Payment
Amount

Total
Interest

5
years

60

$94.36

$661.60

3
years

36

$149.85

$394.76

1
year

12

$428.04

$136.45


INTEREST
RATE ON THE LOAN
Lenders
charge you a certain percent of the amount you are borrowing
every year. This is
the annual interest rate, sometimes referred to as the nominal interest rate.
This rate is used when calculating the interest
expense on your loan.

Let’s
check how different interest rates affect the price of a
fiveyear, $5,000 loan, again expressed in monthly
payments:
Int
Rate

#
of Pymts

Pymt
Amount

Total
Interest

3%

60

$89.84

$390.61

5%

60

$94.36

$661.60

10%

60

$106.24

$1274.11

Using financial calculators, you can plug in different interest rates and different lengths and see what happens to each payment and the total cost of the loan.
ANNUAL PERCENTAGE RATE
You’ve looked at both your interest rate and the length of the loan.
Now you need to add up all the finance charges
and other fees that the lender may demand.
Assuming
you are not a math genius, how do you compare a $5,000 loan
at 5% interest over five years with a $400 origination fee,
with a $5,000 loan at 4% over three years with an annual fee
of $30 and an origination fees of $85?
Until
1974, it was just about impossible to compare them. In
that year, however, Congress passed the Consumer Credit
Protection Act.


Also referred to as the TruthinLending
Act, the Consumer Credit Protection Act included the government’s standards for annual
percentage rate
calculations. Ever
since then, all lenders are required by law to tell you
their annual percentage rate as well as their nominal
interest rate so that you can better compare one loan to
another.
It’s
best to think of the APR (annual percentage rate) as the
allinclusive rate on a loan.
In addition to the stated interest rate on your
loan, it includes how fees, points and closing costs
affect the interest rate.
The
annual percentage rate is figured like this: You add up the
interest for one year and every finance charge.
With some loans, especially home mortgages, there can
be ten or twenty kinds of fees like appraisal, credit
report, processing, origination, etc.
Let’s
look at our $5,000, fiveyear loan at 5% interest, but this
time we’ll add a $100 processing fee. We are now borrowing
$5,100.
Our
monthly payment goes up to $96.24
(instead
of $94.36
shown in the first table),
and
our total interest becomes $774.60 (not $661.60).
The APR is 5.819%.
Loan
Amt

Fees

Term
(yrs)

Int.
Rate

Total
Int.

APR

$5100

$100

5

5%

$774.60

5.819%

$5000



$400

5

5%

$1114.28

8.218%

$5000

$115

3

4%

$436.55

5.515%

To compare APRs on the other two examples: a $5,000 loan at 5% interest over five years with a $400 origination fee has an APR of 8.218% (total interest of $1,114.28).
The other $5,000 loan at 4% over three years with a processing fee of $30 and an origination fees of $85 has only $436.55 total interest and an APR of 5.515%. In this case, the APR tells the story.
The government wanted APRs to provide a way of comparing loans, but APRs are not perfect. In comparing APRs from different lenders, the biggest challenge is in understanding the lender’s use of actual or estimated closing costs included in the APR calculation.
With “balloon
payment” loans, for example, you pay so much a month
for so many years, and then a big payment is due.
Credit card loans can be hard to compare because of things
like penalty fees, interest rates that can change, and other
factors.
With mortgages, fees like escrow, notary, attorney, home
inspection and many others are NOT included in the APR.
See what you learned.
Check out
"Verrry Interesting"and
"The Lowdown
on Loans" 
