Borrowing money comes at a cost, simply put. This is because lenders need an incentive to take on risks associated with a new loan. These risks include default, maturity (long terms allow for value volatility), liquidity (loans tie up loose cash for extended periods) and inflation. Borrowers also add their own risks to the equation. A new borrower may have little or no credit history, which blurs the lender’s vision of the candidate’s reliability with credit. Thus, to compensate lenders for these risks, they tack on an interest rate on their loans.
The interest rate is a premium lenders put on a new loan to compensate for associated risks. For example, suppose you take out a $100,000 mortgage due in 30 years. The interest rate on this mortgage is 6 percent. Therefore, your annual interest payment for the next 30 years is $6,000. This reflects the bank’s “fee,” which you pay to obtain the privilege of borrowing $100,000. It is what the bank wants to earn for allowing you to use its capital.
Annual Percentage Rate (APR)
However, the interest rate is just one “fee” the borrower has to pay to obtain a new loan. Mortgage lenders, for example, typically include other expenses such as closing costs, origination fees, points and appraisal fees. This increases the cost of borrowing and is not reflected by the interest rate. Therefore, lenders are also required to report the annual percentage rate (APR) to potential borrowers. Unlike the interest rate, the APR reflects associated loan costs as a percentage of the total amount borrowed.
The Truth in Lending Act
Passed in 1968, the Truth in Lending Act (TILA) was instituted to promote the informed use of consumer credit. Since then, lenders have been required to provide full disclosure of credit terms (on mortgages, credit cards, for example), particularly those concerning the costs of borrowing. One result of this act is the requirement of lenders to post the annual percentage rate (APR) next to the loan’s interest rate, which also serves to standardize lending cost reporting to allow consumers to shop for the best rates. Furthermore, the TILA gives consumers certain credit rights including the right to cancel transactions regarding liens on principal residences, the right to a fair and timely resolution of credit billing disputes, and protection against unfair credit card practices.
The APR is not a particularly useful tool for calculating borrowing costs regarding adjustable-rate mortgages (ARMs). The nature of ARMs is that their interest rates fluctuate, adding to the challenge of forecasting borrowing costs. Furthermore, some upfront borrowing costs (for example, appraisal, title and credit reporting fees) are not included in the calculation of APR. Therefore, borrowers should make sure to ask their lender for a good faith estimate of all costs involved with the new loan.
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