What is Annual Percentage Rate (APR)?

Before taking out a loan or other form of credit you need to consider the interest rate, often applied as an Annual Percentage Rate (APR). This will determine the cost of the loan, i.e. the amount you will have to pay on top of the principal. It's all good getting offered a large unsecured loan, but if you can't afford the interest then you will get in to a difficult financial spot.

Knowing and understanding the rate of interest will also help you shop around for the best offer instead of taking the first one you see.

So what exactly is the APR?

If you take the principal amount which is the amount you borrow, the APR is a percentage of that. So if you borrowed $200 at an APR of 10%, the amount of interest you pay in the year is $20. This will be split in to intervals depending on how often your payments are due. Usually it will be monthly. So in the same example you would pay just $1.60 in interest a month, which is on top of the principal. Actual rates will likely be much higher.

It should also be noted that if your loan period is less than a year, you will still be paying as if it is. For example if it was 4 months, you'd still be paying the $1.60 for those months.

One issue you may face with loans such as payday loans is not actually being told the APR upfront. They must tell you this in the offer, but if you're just browsing the site for information it might not be listed. You can however calculate the APR yourself if you know the loan fee.

The loan fee is a lump sum you pay on top of the principal. Because payday loans are a short term commitment you only make one single payment a couple of weeks after it is issued. Under normal circumstances you don't necessarily need to know the APR, but if you fail to make the repayment the interest will then be applied, so it's wise to know it anyway.

So if your fee is $30 on a $200 payday loan over 2 weeks, the APR is first calculated by multiplying that fee by the number of intervals in a year. There are 26 fortnights in a year, so $30 multiplied by 26 is 780.

You then take the 780 and divide by the principal. 780 divided by 200 is 3.9. You must then multiply this by 100 to get the APR percentage rate.

The APR in our example is 390%.

This may seem like a lot, but remember if you meet the loan agreement you should only be charged one single fee of $30. It is only when you default that this interest starts to be charged, and this is only charged for the time the balance is outstanding.

This is why you should only apply for a payday loan if you genuinely need it for a short term emergency that you can cover with your next pay check. As long as you are responsible they can be the best solution out there.

In the United States APR is regulated by the Truth in Lending Act which was first passed in 1968 and updated in 1987. It states that the APR must be clearly disclosed to the borrower, within at least 3 days for those applying for mortgages. The figure must also include any related charges and fees, so the borrower is not confused by multiple figures.

Variable APR

Certain types of credit (mainly credit cards) can come with a variable APR. This means the rate can actually change, becoming more or less costly. This will usually be pegged to an index, such as the prime index published by the Wallstreet Journal.

It's rare that there will be a drastic change, but its a risk everyone needs to take in to account.