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Suppose you borrow £120, repayable
in installments of £40 at monthly intervals. The lender charges
an organizational fee of £5 for his services. Note that the
repayments add up to £120 so the annual interest rate is zero
which makes it a interest free loan but There is a non-zero APR,
though, due to the fee which makes the total repayment £125.
That small up-front fee, when applied to a three-month loan,
gives an APR of a whopping 29.2 per cent.
However in the other bank the same
total £125 repayment over a longer period reduces the APR. Even
paying it over three months but handing over the £5 at the end
of the loan rather than at the start will give a better APR and
therefore the second bank gives a better value loan. This is
because The APR formula is based on the method for calculating
compound interest. A consequence of this is that APR is
sensitive not only to the amounts paid but also on the amount of
time required. Although in the above example the difference in
true cost is tiny but if we apply the same logic to a car or
house loan spanning years than the sums are magnified into
significant amounts of money.
APR advantages
Rate of interest can always be misleading. A ten percent annual
interest can be made to look in thee different ways:
• 0.7974% effective monthly interest rate
• 9.569% annual interest rate compounded monthly
• 9.091% annual rate in advance.
As you can see the above rates are all equivalent but to a
person who is a novice in finance it is totally misleading. APR
helps to standardize how interest rates are compared, so that a
10% loan is not made to look cheaper by calling it a loan at
"9.1% annually in advance"
APR disadvantages
APR do not show the total cost of
borrowing
Although proponents of APR claim that it includes all real time
fees however some set of charges are deliberately excluded which
makes the tall claims about APR look hollow. Excluded fees may
include:
• Routine one-time fees: This fee is paid to someone other than
the lender such as a real estate attorney’s. Supporters of these
fees argue that the attorney's fee is a separate transaction and
not a cost of lending. This is true because attorney’s fees are
not the same everywhere, and also the customer is free to select
which attorney he wants. But if the lender insist on a specific
attorney then the cost should be looked at as a component of the
total cost of doing business with that lender
• Penalty fees: certain fees such as late fees or service
reinstatement fees defer from customer to customer. So bankers
argue that including late fees and other conditional charges
would require them to make assumptions about the consumer's
behavior—assumptions which would bias the resulting calculation
and create more confusion than clarity
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