Why Is the APR Higher on Short-Term Loans?
The annual percentage rate, or APR, is a consumer financing tool used to compare one loan offering with another. The APR is NOT the interest rate. Rather, it is the cost of money borrowed, expressed as an annualized rate.
Lenders are required by law to disclose the APR to consumers before a consumer loan can be issued. The APR is truly effective when comparing the exact same loan type from different lenders. On the flip side, the APR is not as useful a tool when comparing different types of loans.
The APR can be a confusing number mainly because it can be difficult to explain to the borrower in everyday language. In fact, many loan officers have trouble properly explaining what the APR is and is not.
The APR is not the interest rate a borrower pays on a loan. A loan consists of four basic elements; the interest rate, the loan amount, the loan term and the payment. The interest rate, expressed as a percentage, is an amount due the lender as compensation for extending a loan to a borrower. If a loan has an interest rate of 10.00 percent, the lender will receive interest revenues of 10.00 percent of the loan each year.
The APR looks at all finance charges required by or incurred on a loan – including all interest charges.
The APR number considers the cost of borrowing. Along with an interest rate, a lender may also require other fees before a loan can be issued. A lender might have a loan processing fee, a loan application expense or a charge for a credit report. Finance charges are considered as the cost to borrow money.
The annual percentage rate reflects those additional costs including the note’s interest rate. If a lender had no fees whatsoever other than the interest rate charged on the loan, the APR and the interest rate would be the same.
For example, a 30-year loan amount of $200,000 with a 5.00 percent rate has a monthly payment of $1,073. If the lender also charged a $500 application fee and a $2,000 origination charge, additional fees would total $2,500. This additional $2,500 in finance charges would result in an APR of 5.22 percent.
The higher the lender fees the higher the APR is in relation to the interest rate.
Another way to manipulate the APR other than adjusting fees is to change the loan term. Using the same example as above but with a ten-year loan instead of a 30-year loan, the APR is 5.27 percent. The shorter the loan term, the higher the APR. Even though the interest rate and the loan amount is exactly the same, by shortening the length of the loan the APR goes up.
What is the APR on that same loan with a one month loan term instead of 10 years? It would be a whopping 20.06!
The reason why a shorter term can increase the APR is that the borrower has less time to pay off those additional finance charges. This is particularly true if the non-interest finance charges are basically fixed, regardless of the loan term.
Consequently a shorter loan term creates a greater variance between the interest rate and the APR.
Is the APR a useful consumer tool? Of course it is – when properly used and applied. But comparing the APR across the board for all loan types and terms can sometimes be a fruitless exercise, as it would be like comparing apples and oranges.