In simple terms, the APR is a measure of how much a given loan or mortgage will cost you in interest per calendar year. It's easy to work out, as is calculated by dividing the interest (charges) paid in the first year by the size of loan (i.e. capital outstanding), expressed as a percentage (i.e. multiplied by 100). 

The figure for the APR takes into account all of the normal costs associated with the loan, such as arrangement fees, any annual charges (which may be the case with credit cards) along with other such costs so as to provide a clear, overall figure for the total cost of the loan. This makes is possible to compare one APR with another. The cheaper APR percentage will be the cheaper loan. But comparing APRs with other types of rates is not entirely straightforward.

This page provides an illustrative example of why an APR rate is usually much cheaper than an apparently similar Fixed Rate (i.e. where the percentage rates are similar.)

Suppose you are looking for a 6 year loan of £1,000. One loan quotes you a flat rate of 5%, and the other an APR of 6%. Car dealers often do this, and quote a 'flat' rate... Which is cheaper?

In fact, you can't compare these numbers:  they may look very similar at first, but are actually very different. Depending on the exact calculation, an Annual Percentage Rate of 6% will usually be much cheaper than a flat rate of 5%. This is because:

• the flat rate is applied to the whole of the loan every year (and usually the loan lasts several years)
• the Annual Percentage Rate is calculated on the amount outstanding, which is reducing each year; because you are paying the loan back on a regular basis, the interest payment you make reduces.

The table below shows, approximately, the interest payments you would make using the two different calculations. (note: this is just the total INTEREST for each year. Your monthly payments would also include an amount to pay back the capital (£1000/6 years = £167 per year or £13.89 per month)The table below

Year	Fixed	APR
1	£50	£60
2	£50	£50
3	£50	£40
4	£50	£30
5	£50	£20
6	£50	£10
Total	£300	£210

The above table is to illustrate the principle only; the calculations are not accurate and the actual amount payable using an APR of 6% would actually be much less than £210.

Nevertheless, you can see that the 'Fixed' calculation does exactly what it says: the interest is fixed for each year.

However, with the APR calculation the interest changes each year. It is worked out as a percentage of the amount you still owe. After the end of the first year you have paid some of the loan back, say approximately £140, so your loan has been reduced to £860. The new interest calculation is therefore 6% of £860. Each year the amount of money you owe reduces, so you pay less and less interest.

Fixed monthly payments

However, you may wonder, in view of the explanation immediately above, why your monthly repayments usually don't reduce when interest is calculated using APR. This is because it is standard practice for lenders to keep your regular payments fixed, so that you can budget a regular amount and not have to pay more in the early years.  

(Remember, this is for traditional loans - credit cards do not work like this - the interest is calculated on what you owe each month, and providing you pay off more than the interest each month, the amount you owe will decrease and so will your payments. WATCH OUT for credit cards where the minimum monthly payment is not enough to cover the interest; in this case the amount you owe will increase each month. I have seen an MBNA card like this.)

The lender does this with a clever calculation when working out how much of the loan you repay: the lender increases the amount you repay (of the capital) as you go through the loan. This compensates for your reducing interest rates. In the above example, your total monthly repayments, including interest and loan repayment, would be £210.66. Although the overall total stays the same, in later years your loan repayment increases whilst the interest payment reduces, as shown below:

But remember, this is just an 'accounting convenience' - it doesn't change what you back overall, and it doesn't change the APR.

The maths for calculating APR is not entirely straight forward (even though it sounds as though it ought to be), especially when a loan has been adjusted to provide fixed monthly payments. As you can see from the table above the interest rate appears to change each month, so there's no way you can work out the APR in your head.

What you can do with the above example, though, is work out the equivalent flat rate. You pay £210 in interest on a capital of £1000 - i.e. 21% over 6 years. The equivalent yearly interest rate is 21%/6 = 3.5%. That is, each year you back an additional 3.5% of the amount you borrowed in interest. By the end of loan you have paid 21%. You can see that our APR of 6% has an annual equivalent of 3.5% 'flat' and therefore is indeed much cheaper than a flat rate of 5% quoted for 'loan 1' in our example.

How the money system works

you might also be interested to get some insight into generally how economies and the money system works, because debt (loans, mortgages etc.) actually plays an important, if not pivotal role. The video above entitled "money as debt", is very good, and gives a clear explanation of how money is created and accounted for in the American money system (which also applies to the UK and most other developed countries.) It tells in very simple and effective graphic terms what money is and how it is being created. It is an entertaining way to get the message out. The Cowichan Citizens Coalition and its "Duncan Initiative" received high praise from those who previewed it.

http://video.google.com/videoplay?docid=-9050474362583451279

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