The Annual Percentage Rate: the real cost of credit

The other conspicuous disclosure on every Truth-in-Lending disclosure form is the Annual Percentage Rate, or APR.  Expressed as a percentage (%), the APR is defined as “the cost of your credit as a yearly rate.”

Behind this seemingly simple definition lie several different ideas.

One:  the APR is based on the Finance Charge, which I discussed in my last post.  That is, every cost imposed in connection with using credit rather than cash, unless it’s specifically excluded from the Finance Charge by law, also contributes to the stated APR.

Two:  The APR, unlike the Finance Charge, reflects the length of time that the credit is being extended for.  You can intuit, through a simple example, that duration is an important element of a credit transaction.

Suppose I offer to lend you $100 today and charge you $6 for the privilege.  Would you rather have to pay me back $106 at the end of a year, or at the end of six months?   Of course, you benefit by having the use of my money for the full year.  I, on the other hand, benefit by having it back after six months, for then I could lend it out again to someone else and make another $6!  Your intuition is correct.   The first deal carries an APR of 6%.  The latter deal carries an APR of 12%.

In the real world, unlike this example, finance charges are usually not flat,  but are proportional to the length of the contract.  But some fees are flat, such as the application fee for a loan, or the service charge for a “rapid refund” of your income taxes.   All things being equal, keep in mind that the shorter the duration of the transaction, the more expensive this charge is.  Indeed, some of the most abusive lending practices involve extending very short-term credit.  Only when expressed as an APR is its true cost revealed.

“Refund Anticipation Loans”  offered by tax preparation companies are a notorious example of short-term credit that may seem reasonably priced, but when expressed as an APR, is shown to be astronomically expensive.  Tax prep services are required to give TILA disclosures, but often hide them at the back of the folder containing your completed returns and other papers, hoping that you won’t look too closely.

Recently H & R Block, the largest tax preparation chain in the country, announced that will no longer offer RALs.   This announcement was greeted with satisfaction by the National Consumer Law Center and other consumer groups that have criticized these loans as predatory.  Only one national bank is continuing to fund RALs offered through a tax preparation service.

Three:  in my next post, we will look more closely at the math behind the APR, especially in the most common kinds of sales or loans, those in which you pay down the initial extension of credit in monthly or weekly installments.



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