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Financial Literacy

Understanding your APR

When you’re shopping for a personal loan, the first thing you’ll likely want to know is what the interest rate will be. Interest rates don’t tell you everything you need to know, because interest rates alone don’t take into account any fees you may be charged during the life of your loan, such as the origination fee.

When you’re shopping for a personal loan, the first thing you’ll likely want to know is what the interest rate will be. But when you’re figuring out the total cost of a loan, interest rates are just the beginning. They don’t tell you everything you need to know, because interest rates alone don’t take into account any fees you may be charged during the life of your loan. One good example is the origination fee, a one-time fee the loan provider charges for processing the loan.

Most lenders charge an origination fee. Some set a dollar amount, but lenders usually structure the fee as a percentage of the loan amount. For example, online lending platforms like Prosper.com charge origination fees that range from 2.41% to 5%. Your credit rating may determine the origination fee.

For example, if you borrow $5,000, you would be charged an additional $50 to $250 on top of the interest rate. Borrowing $10,000 would cost you between $100 and $500 in origination fees.  Depending on the loan product that you select, the origination fee may be taken out of the loan proceeds (borrow $10,000 and receive $9,500 in funds) or charged in addition to the proceeds (borrow $10,500 and receive $10,000 in funds).

The origination fee isn’t included in the interest rate, which can make it hard to know whether or not you’re paying it. To consider them together, you’ll need to understand your APR.

What is APR?

Your interest rate is determined by your creditworthiness, the length of the loan and other factors. Personal loans have a fixed rate, so your payments won’t fluctuate from month to month. Instead, you’ll be charged equal monthly installments.

But that’s not all of what you’ll be charged in order to borrow. APR, or annual percentage rate, provides a clearer picture of your loan’s true cost because it reflects your loan’s annual interest rate including all fees to originate the loan. Like the interest rate, APR is expressed as a percentage.

APR is a good way to compare loans from different loan providers and lending platforms so you can make apples-to-apples comparisons, even if you are quoted the same interest rate for different loans. In some cases, a loan with a higher interest rate but a low origination fee could end up costing you less because its APR is lower after factoring in the origination fee.

APR is a complicated mathematical formula, so it’s best to use an online calculator to run the calculation. To do so, you’ll need the following pieces of information:

  • Your loan amount
  • The length of the loan
  • Interest rate
  • Origination fee

Loan providers are legally required to provide you with both your interest rate and APR as part of any loan agreement.

Several ways to pay origination fees

The origination fee reimburses lenders for performing due diligence, like pulling your credit report and verifying supporting documents. Most personal loan providers charge an origination fee, but they don’t all charge it the same way.

Some require you to pay your origination fee right away by deducting it from your total loan amount. Let’s say you take out a $5,000 loan with a 2% origination fee, making that fee $100. At closing, you would only receive $4,900 because the lender would hold back $100 to pay the origination fee. However, you would be required to repay — and pay interest on — the full $5,000. In this case, it’s easy to see how much you’re paying because you do not receive the full amount of the loan.

Other loan providers add the origination fee to your loan total. Using the same example, if you wanted to borrow $5,000, you would be required to repay $5,100 plus interest, which would result in slightly higher monthly payments than the upfront method.

You may prefer one method or the other, depending on your circumstances. Paying off the origination fee over the life of the loan may be easier to handle given other constraints in your budget. You may not have enough funds on hand to pay the fee upfront, which may be the very reason you are taking out a personal loan in the first place.

On the other hand, you might object to the higher borrowing cost associated with rolling the origination fee into the loan amount, and you may prefer to pay the fee upfront and not owe additional interest.

Take the time to research how your loan provider approaches origination fees. If you need to borrow an exact amount, you may end up coming up short if your loan provider deducts the fee from your loan total. In that case, consider borrowing more to make sure you’re covered.

There’s no such thing as a free lunch

Many lenders tout “no fees,” but it’s important to remember you are still being charged by the lender for the loan. Whether you’re paying the origination fee over time or whether it comes out of your loan total at closing, you’re still paying the fee. When the fee is rolled up into the loan amount, it can obscure the fact that an origination fee is being charged, but it’s still there in the form of higher monthly payments.

Comparing the APR for different loan options gives you the transparency you need in order to determine which loan is best for you.

Because there’s no such thing as a free lunch, make sure you understand what the origination fee is and how you must pay it.

Only then can you best decide which repayment method makes the most sense for you and your unique circumstances.

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