According to the federal government’s Truth in Lending Act (TILA), APRs are defined “as the cost of credit expressed as a yearly interest rate.” The key word being “yearly.” APR accounts for the entire cost of the loan, including all fees and interest.
While APR calculations work well for comparing loans with terms over one year, such as automobile loans and mortgages, they can be confusing or misleading when applied to short-term loans like payday loans or small personal loans.
Short-term loans
When evaluating short-term loans, keep in mind many of them typically last between 4 and 12 months. The monthly payments include all fees that go with the loan.
To get the APR on a 4-month loan, you’d have to extend the terms you were going to pay on that loan for a year. Since the installment loan will be paid off completely after just four months, the most important aspect is to have a set payment which fits into your budget, and to understand how much you are paying back versus how much you borrowed.
Do not assume that a larger loan is your best choice just because it has a lower APR. Check out the table below provided by the American Financial Services Association Education Foundation (AFSAEF.)
|
EXAMPLE |
1 |
2 |
3 |
4 |
5 |
6 |
|
Length of Loan (Months) |
1 |
6 |
6 |
12 |
24 |
24 |
|
Amount Financed |
$500.00 |
$500.00 |
$1,000.00 |
$1,000.00 |
$1,000.00 |
$2,000.00 |
|
Monthly Payment |
$546.00 |
$102.45 |
$193.58 |
$106.05 |
$63.07 |
$121.05 |
|
APR |
110.00% |
74.88% |
53.43% |
47.02% |
43.46% |
38.77% |
|
Total Payments (Cost) |
$546.00 |
$614.70 |
$1,161.48 |
$1,272.60 |
$1,513.68 |
$2,905.20 |
|
Finance Charge |
$46.00 |
$114.70 |
$161.48 |
$272.60 |
$513.68 |
$905.20 |
As you can see, the first example above has the highest APR, but also has the lowest amount of total finance charges. As the terms of the loan are extended or increased, the APR continues to decrease, but the total finance charges go up.
Likewise, let’s look at what a typical vehicle loan looks like when the APR holds steady but the length of the loan changes.
|
Length of Loan |
4 years |
5 years |
6 years |
|
Amount Financed |
$25,000 |
$25,000 |
$25,000 |
|
Monthly Payment |
$563 |
$459 |
$389 |
|
APR |
3.85% |
3.85% |
3.85% |
|
Total Payments |
$27,024 |
$27,540 |
$28,008 |
|
Finance Charge |
$2,074 |
$2,540 |
$3,008 |
While the monthly payment was $174/month cheaper for a 6/year loan versus a 4/year loan, the total cost to pay off the loan was $934 more. This example shows other factors besides APR should be considered by consumers when choosing a loan.
A short-term installment loan may fit into your budget with equal payments over the life of the loan. Also, some lenders don’t charge pre-payment penalties if the borrower pays off the loan early. Doing so simply reduces the interest they’ll pay by shortening the life of the loan.
Just remember, the APR and the interest rate are generally not the same, as APR will include any fees or additional charges which may apply. The APR may not be a useful number when applied to a loan term of less than one year. When considering a short-term installment loan the most important thing is to make sure you choose a loan with terms that fit your budget, and that you understand to amount being paid back versus the amount you borrowed.
Want more resources regarding this topic? We've created a page called Personal Loan Basics to provide you with more information.
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