Interest is what a lender charges you in exchange for allowing you to borrow money from them. The interest rate is the interest charged as a percentage of the amount that you are borrowing, expressed in annual terms. Interest is commonly charged monthly. For example, when you make your monthly mortgage payment, a portion will go towards your mortgage principal and a portion will go towards the mortgage interest. Your interest portion is determined by your mortgage rate.
The annual percentage rate includes not just the interest charged, but also any other fees or charges from your lender. These are one-time fees that are usually paid when you apply for the loan. In the case of mortgages, the fees and charges that are included in the APR calculation include:
Charges and fees to exclude from the APR calculation:
Use this APR formula if you are calculating the APR for a simple interest loan.
For example, let’s say that you borrowed $100 for 30 days. You were charged $2 in interest and paid a $1 fee. You pay back the entire amount borrowed ($100) at the end of the 30 days. Your APR would be calculated as:
If you calculated just your interest rate and excluded the fee charged, you would have gotten an interest rate of 24.33%. With the fee included, the APR is 36.5%.
Mortgages, personal loans, and car loans are amortized, which means that you make scheduled payments at set periods of time. Your payments are split into portions that go towards your principal balance and interest. As your principal is reduced with each payment, the portion of your payment going towards interest is also reduced, while the portion going towards your principal will increase.
When calculating the APR for an amortized loan, you will use the average principal balance outstanding for the entire life of the loan, rather than just the loan amount that you borrowed. You can estimate the average principal outstanding by dividing the original loan amount in half. The actual average would be less than half, as the interest portion of payments is larger at the beginning, while the principal portion is larger near the end of the term.
APR is used because it reflects your true cost of borrowing. Canada’s Bank Act requires banks to disclose the cost of borrowing when a borrower is applying for credit. This ensures that borrowers are informed about how much it will cost them and APR’s standardized calculation allows them to compare with other lenders.
Cash 4 You is a payday lender that offers payday loans in Ontario. Ontario’s Payday Loans Act regulates the maximum cost of borrowing for payday loans. Cash 4 You charges $15 for every $100 borrowed. While most payday loans must be paid back in 2-4 weeks, the maximum allowed term in Ontario is 62 days.
If you borrowed $100 for 62 days, your APR would be 88.3%.
Many credit cards in Canada offer promotional or introductory rates for new applicants. The Tangerine Money-Back Credit Card offers a balance transfer promotional offer rate of 1.95% for 6 months, with a 1% balance transfer fee.
If you transferred over and borrowed $1,000 during the promotional period only, you would be charged an initial balance transfer fee of $10. The promo rate of 1.95% is stated as an annual rate.
To simplify, assume that only interest payments are made. The interest over six months would be $9.75 (from (1.95%/2) x $1000)).
The APR including the balance transfer fee would be 3.95%.
The longer the term of your loan, the more time there is for your fixed costs to be spread out over. For example, a home appraisal would cost the same whether you are looking to get a mortgage with a one-year term or a five-year term.
Private mortgages have short term lengths and private mortgage lenders private mortgage lenders often charge significant fees. To see how APR is affected by the duration of your loan, let’s look at a six-month private mortgage and a two-year private mortgage. If there are the same fees charged, such as lender fees, broker fees, and appraisal fees, then the six-month mortgage will have a higher mortgage APR compared to the two-year mortgage.
If a homeowner wanted to borrow for two years with six-month terms, they would need to renew their six-month mortgages three more times. Some private lenders may charge a renewal fee that is lower than initial lending fees, while others may charge fees just as they would for a new mortgage. In comparison, the homeowner could have paid them just once with a two-year mortgage.