4.2.3 The cost of borrowing
- 4.2.1 How credit works
- 4.2.2 Credit options
- 4.2.3 The cost of borrowing
- 4.2.4 The effect of interest
- 4.2.5 The cost of different types of credit
- 4.2.6 Case study: Deferred payment plan
- 4.2.7 Payday loans
- 4.2.8 Tips to keep borrowing costs down
- 4.2.9 Joint borrowing
- 4.2.10 Rights and responsibilities
- 4.2.11 What to know before you sign a loan agreement
- 4.2.12 Summary of key messages
How much does it cost to borrow money? To know the answer, you need to know the annual percentage rate and how the interest is being calculated.
- The annual percentage rate (APR)
This is the actual rate of interest charged on a loan each year. Because the APR is calculated using standardized rules, it can help you compare rates from one loan to another.
A lender must tell you the APR before you sign a loan agreement. To understand the APR of a loan, make sure you ask:
- How much total interest will I pay?
- Are there any fees or extra charges?
- Are there any other costs, including loan insurance? (For example, with a mortgage loan, you must get mortgage insurance if your down payment is less than 20 percent of the principal.)
- How the lender calculates the interest
The method that is used can change the cost of borrowing. For example:
- With mortgages and other loans, lenders use the remaining balance method. They multiply the interest rate by the principal balance at the start of the term. Each payment includes some of the principal amount. You don't pay interest on any principal you have repaid.
- With credit cards, if you pay the balance in full by the due date, you're not charged interest. However, if you don't pay off your balance in full each month, you will be charged interest from the day you made each purchase until you pay in full. With different cards, you may pay interest on your daily balance, your average daily balance or your highest monthly balance. For example, a credit card with an APR of 28.8 percent that is compounded daily has an effective rate of 33.36 percent.
- For cash advances and balance transfers, you are charged interest from the date you made the cash advance or balance transfer until the date you repay the amount in full.
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