Two factors affect the cost of borrowing: the annual percentage rate and the method used to calculate the interest.
1. The annual percentage rate (APR)
The APR includes all loan service costs and interest. It may be higher than the interest rate you see in the loan contract. A lender must tell you the APR before you sign a loan agreement.
To understand the APR on a loan, ask:
- how much interest you’ll pay in total,
- if there are any fees or extra charges, and
- if there are any other costs, such as loan insurance.
2. How the lender calculates the interest
The way interest is calculated will affect the cost of your loan. For example, interest on a mortgage is calculated in a different way than interest on a credit card.
Most mortgages use the remaining balance method. The lender multiplies the interest rate by the principal balance at the start of each term. You don’t pay interest on any principal you’ve repaid.
With credit cards, you have to pay off all of your charges each month. If you don’t, you’ll pay interest on the full amount you owe. With some cards, you pay interest on your daily balance, or your average daily balance. With others, you pay interest on your highest monthly balance.
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