How much does your loan REALLY cost?
The Actual Annual Interest Rate (APRC) is an indicator that frightens – usually by its amount, and those who are determined enough to check how it is calculated, also by the formula.
Fortunately, not as the devil as it is painted. In addition, this particular devil can be very useful, especially if you run a business.
In this text, we’ll show you what the APRC is, how to interpret it, how it differs from other credit assessment measures, and finally – how to calculate the APRC quite accurately, even in your mind.
What is APRC?
The APRC functions formally in the world of consumer loans – the name Real Annual Interest Rate comes from the Consumer Credit Act. However, nothing prevents you from applying it also to corporate loans, especially since the APRC has a universal concept of internal rate of return (IRR). This indicator is widely used in business to assess the profitability of investments.
As per the definition from the Act, the Actual Annual Interest Rate is “the total cost of credit for the consumer, expressed as a percentage of the total loan amount per annum.”
In the case of corporate loans, the lender is not required to provide APRC. In a sense, this is a paradox, because as you will soon find out, the Real Annual Interest Rate is particularly useful in business.
The definition from the Act captures some very important features of the Real Annual Interest Rate:
- it is calculated on the basis of the total cost of the loan, i.e. interest, commissions, fees, insurance costs and all other costs that the customer must pay to the lender;
- these costs are recognized as a percentage of the total loan amount …
- … however – and here there is some difficulty and a source of controversy related to the APRC – both the costs and the amount of the loan are recognized on an annual basis.
The actual Annual Interest Rate stated in the advertisement or on the website may not necessarily apply to you if you decide to take a loan. In the case of consumer loans, the individually calculated APRC should be presented to the customer before the conclusion of the contract and should be clearly indicated in the contract itself.
How to interpret the APRC?
To put it simply, the Real Annual Interest Rate answers the question: What would be the interest rate on a given loan per year so that it could replace all related costs (including commissions or insurance). In a sense, it can be said that this measure is real interest on the loan.
This is not a big exaggeration: after all, in the name of the indicator, we have a similar word real.
Due to the fact that the APRC reduces all costs related to the loan to one number, comparing the offers of individual lenders becomes much simpler than it would be if we compared each of the parameters separately.
It is enough to imagine such a question: is a low-interest rate and high commission better, or maybe high-interest rate and lower commission? The answer is not obvious, but the Real Annual Interest Rate gives it right away.
Unfortunately, her indications cannot be uncritical.
The APRC does not inform, for example, about the absolute amount of costs. Two different loans granted for the same period and for the same amount can have the same APRC and different total cost sums.
The universality of the Real Annual Interest Rate has its limitations in practice. For example, you can easily calculate the APRC for payday loans for USD 1,000 per week and a mortgage loan for USD 300,000. USD for 30 years. Comparing both loans does not make much sense, if only because no reasonable person would finance the purchase of the apartment with payday loans.
Since we have mentioned payday loans, it must be said that the APRC is particularly unkind for short-term loans. This is mainly because of one-off costs (commissions and fees) in this case constitute a significant part of the costs. Meanwhile, the APRC tells us the average annual cost of financing with a given loan. Counting it for short-term loans, we act – figuratively speaking – as if we were taking out several more loans to “fill” them with the whole year.
Example? If we were to finance our expenses with a 3-month loan, we would need 4 such loans for a year. This means that for the purposes of calculating the APRC, commissions and all one-off fees are included four times. With “payday loans” the matter looks even worse – in the case of a loan granted for a week, commissions and fees incurred for “good morning” are calculated 52 times! This is why the APRC ratio for short-term loans can be very high, reaching hundreds of percent or even exceeding 1000%.
With such values, the APRC loses part of its informative value (after all, the short-term loan customer is mainly interested in answering the question “how much will I have to give back?”), But is it still suitable for comparing similar products with each other. In addition, it perfectly illustrates the scale of revenues that loan companies realize on those who pay their liabilities reliably. And this is probably the real reason for the reluctance of loan companies to APRC.
The shorter the loan term, the higher the APRC in general. Therefore, when comparing loans, you should compare similar loans in terms of the loan period.
APRC versus the total cost of credit
Opponents of the APRC, especially those representing the short-term lenders camp, argue that the loan costs are better illustrated by the total cost of the loan: a simple sum of all costs (from interest to various fees) in dollars. Ultimately, they argue that the client is primarily interested in how much money he will have to pay for the loan.
For consumer loans, this is true to some extent – when you buy a TV in installments, you are primarily interested in how much extra you pay for it. Similarly, for short-term ad hoc loans, you will probably be more interested in the sum of costs than anything abstract APY. You will probably prefer to pay USD 500 for USD 5,000 borrowed for 3 months than USD 700 for the same amount for half a year (even though the second loan has a lower APRC).
In business, however, it is completely different. In business, you should be primarily interested in the APRC.
Unlike a private wallet, money should work in the business. In business, money makes money.
APRC informs you directly how much each borrowed dollars costs you annually. If it costs you less than you can earn on it at that time (by the way, only in this case you should think about the loan), then having two loans with the same APRC to choose from, there is a good chance that it will be better for you to choose this … higher total cost!