Postmodern economies are predicated on credit. Not only do consumers buy what they can't immediately afford, lenders extend credit based on interest earnings they haven't collected yet. APR financing is the most common method of credit for consumers and is used in buying things like houses, appliances, and cars.
Function
Federal law requires that lenders report an annual percentage rate, or APR, to borrowers for ease in comparing loan offers. Thus, APR is a protection against deceiving lending practices that is used by consumers as a means to "shop around" and evaluate loan offers that might have different maturities and interest rates. By incorporating fixed costs and annualizing the rate, borrowers can make "apples to apples" comparisons.
Identification
APR reflects the difference between the principal of a loan, that is, the amount borrowed, and the total that will be repaid including all interest, fees and charges, expressed as a per annum increase. APR financing is an agreement between a lender and a buyer that is repaid over a fixed number of months. Credit cards and savings accounts will also usually report an APR, but these are often inaccurate because they do not account for compounded interest.
Features
Calculating the annual percentage rate of a loan requires the principal, the annual interest rate, the maturity date and any financing charges or fees. A $1,000 loan that was due back in a year with $500 interest and no other fees would have a 50 percent APR. If the maturity was increased to two years, the APR would be 25 percent. If, there was also a $100 financing fee, the one-year loan would have an APR of 60 percent, the two-year loan 30 percent.
Effects
Interest is generally understood as the borrowing cost of money. By including closing costs, financing fees, insurance premiums on the loan or any other upfront fees and charges, APR reflects a more accurate assessment of the cost by adjusting the interest rate higher. Nevertheless, APR financing probably provides a net savings to the borrower by helping them find the cheapest loan available. The very extension of credit helps every segment of the economy by allowing for consumer spending based on future earnings.
Considerations
Despite the goals of APR financing, there are several different ways calculating APR, and borrowers are recommended to do their own calculations if possible. They should be aware if the lender is using a constant yield method that does not favor early payments. Additionally, borrowers should be aware that on relatively small loans, lenders can adjust the ratio of upfront charges to longer term interest payments without significantly altering the APR.
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