What is APR?

APR or annual percentage rate is an representation of interest rate on annual basis. In simple words APR is cost of borrowing money from bank or any financial institute for period of one year.

Annual percentage rate considers different costs associated with borrowing like, closing fees, administrative fees, late fees, etc. This makes APR one of the good method to calculate the cost of borrowing.

But, annual percentage rate does not consider the compounding of interest wherever it may apply.

APR is also used to compare costs of different loans and credits which may be available by different lenders.

Working of APR

Let us consider example of credit cards to explain working of APR. When you purchase a credit card, the credit card company will provide you with some benefits over the spending done with the card. 

When you spend using your credit card you have to pay back the spent amount within the given due date, doing so will you will not incur any interest. You also have option to carry forward the balance on which interest is charged. Along with this interest there is something called as card fees which is charged annually and if you are late in paying the dues then you maybe charged with additional charges.

These additional charges, card fees and interest cumulated over a year are part of APR.

Types of APR

There are two types of APR: Fixed APR and Variable APR.

• Fixed APR: When you are under fixed APR, the interest rate applied to principal amount of the loan or spent amount via credit card does not change. Also, the APR calculated is fixed which is calculated as per the fixed interest rate. If you have fixed APR then the amount which you will be paying every year will not change.
• Variable APR: A variable APR will keep changing because the interest which is put on the principal amount changes over time. These interest rates are dependent on the changes in the lending rates. So, if there is increase in your interest rate then, your APR will also increase. 

If your APR is high then, you may end up paying more to the lenders via paying more interest on the remaining balance. But, if you repay the borrowed money on time then you would not be charged with APR. The reason for APR not being charged is for the fact that the APR is calculated on the basis of balance amount left. So, if you pay the balance amount in full and within time then the APR will not be applicable to you. 

How to calculate APR?

To calculate APR of your loan you must know your principal amount, period of your loan and any extra costs additional to your interest. 

Calculating APR is a simple process, just follow the steps below:

• Calculate the interest rate of your loan
• Add additional fees associated with your loan to the interest 
• Divide the above calculated amount with principal amount of your loan and its period.
• Multiply the number you get with 100.

Formula of APR:

APR = (Interest +Fees)*100/(Principal Amount + Period of the loan)

Consider below example to understand how APR is calculated:

John borrows $5000 at am interest rate of 7% per annum for 3 years which is not compounded. The bank is charging $300 as administrative cost over the loan.

Before calculating John’s APR we will have to calculate his interest on the borrowed money. 

To calculate interest, we are using simple interest formula that is: A = (P(1 + (r*t))), where A is the total amount, P is principal amount, r is interest rate of the loan and t is time period for which the loan is borrowed.

So, John after 3 years John will have to return (5000 (1 + (0.07*3))) that is $6050. 

Hence, the interest for 3 years will be $6050 – $5000 = $1050. i.e. John has to pay additional $1050 over $5000 which he has borrowed. This additional money does not include other costs like administration fees.

Now, we will add administrative fees of $300 to the interest which is $1050. Sum of two is $1350.

At this final step we have to divide above amount with principal amount and period of the loan and multiply it by 100 i.e. ($1350 / ($5000*3)) * 100 = 9%.

The APR on John’s loan is 9%.

You can see that although the interest rate on the loan is only 7% but in reality, the cost of your loan is 9% when other costs and fees are included. If this loan had interest which was compounded annually still the APR would remain same.

APR on Payday Loans

When looking at the fees for borrowing a payday loan, it may seem inexpensive and you may immediately fork out the fees for instant cash. But, these payday loans are deceptive until you calculate APR and realize how expensive it can be. This gives another reason to look out for other options if you are considering to take payday loan.

Calculation of APR for payday loan is similar to that of calculating normal APR. To calculate the APR for payday loan:

• First divide the borrowing fees by the loan/principal amount
• Multiply the above number by 365
• Now divide the above calculated value by the term of loan and multiply it by 100.

For example, if you take a $200 payday loan that is due on the 14^th day from the day of borrowing and it has borrowing fees of $30. So, the APR will be 391% which is exorbitantly high.

APR and Credit Cards

Your APR will tell your interest rate on credit card but your APR will not show the effects of compounding interests, due to this you will always be paying more than the estimated or quoted APR by the credit facilitator.

When you carry the balance of your borrowed money on credit card, you have to pay interest on the borrowed money and there is also interest on the past accumulated interest. This is the compounding where you have to pay interest over interest and this makes cost of borrowing higher than what you may have anticipated.

Different card companies have different policies some charge only interest and some may have card fees which is charged annually. So, it is advised to do your research while getting a credit card as there are many factors affecting APR on credit cards.

Disadvantages of APR

Overall APR is an easy way to calculate how much you will pay every year over your borrowed money but, this method of calculating the cost of borrowing is not perfect. Using APR as the sole method to calculate the cost is not good because

• Your calculated APR will be accurate only if you know that you are paying your loan within the defined term. But, if you are not able to pay your loan within the defined term or if you refinance the loan then your APR will change.
• APR will vary with the lender and different lenders have different interest rates, fees and policies. Hence, it is advised to thoroughly check interest rates and fees associated with the loan as there may be hidden fees. This hidden fee may not be added up to APR and thus, give you incorrect APR.
• Also, compounding effect of interest rate is not accounted into APR. If your interest is being compounded then you should consider some other metrics to calculate cost of borrowing.

When in need of urgent cash, it becomes difficult to get funds from big financial institutes via traditional ways if the credit scores are at the lower end of FICO score. At such situation options available are Installment loans, which are provided by multiple financial institutes or another option is payday loan, which can be borrowed by any lenders. 

To understand how installment loans are best and better than payday loans, we need to understand terminologies like bad credit, installment loans and payday loans.

What is Bad Credit?

Bad credit is an indicator of poor credit records and is depicted by lower FICO scores. When your credit scores are low, you are considered as a risky borrower. With such considerations it becomes difficult to get loans and funding and, also you do not have most of the privileges which a person with good credit score has. With poor scores you miss on privileges like lowered interest rates, priority funding/loans, more favorable terms and most importantly lower chances of denial.

Impact of bad credit score is not just limited to loans and funding or credit card approvals. With poor credit scores you will also find it difficult to get,

1. Cell phone contracts
2. Student loans
3. Affordable car insurance
4. Job

Poor credit score can impact your chances of getting hired, it is observed that employer tend to check credit histories of the applicant. Employers use credit histories to get sense of dependability. 

What are Installment loans?

Installment loans are loans borrowed at once and the debt is repaid with small fixed payments which are paid at set schedule decided at the time of borrowing. Installment loans has fixed interest rate which is paid with the fixed payment. 

Installment loans are prominently offered by banks and other credit unions and organizations. Most common types of installment loans provided by these lenders are personal loans, car loans, and mortgages. Car loans and mortgages are used to finance specific purchases whereas personal loans can be used for different purposes.

One can use personal loan for building credit score, repay some debts, or to fund every day or personal expenses. Personal loans are easier to get even if the credit score is low as it is possible to give this type of loan without any security or collateral. 

What is a Payday Loan?

A payday loan is a small amount loan which is given a for a very short term. This type of loan is usually paid back in single lumpsum payment by the borrower’s next paycheck. 

Payday loan is also called as:

• Cash advance
• Short-term loan
• Payday advance loan
• Fast cash or fast loan
• Bad credit loan
• Deferred deposit transaction
• Paycheck advance

These types of loans are usually targeted towards poor people or people with no credit score and history, or people who are financially illiterate and in need of urgent cash. But, for people with poor credit score, this is their first option when in need of some cash.

One can get payday loan within a day or so and has very few requirements when compared with other loans. More importantly these lenders do not check credit score or credit history and the loan is unsecured. 

The flip side of payday loan is that the interest charged by lenders for such lending is exorbitantly high. An average payday loan can have interest rate as high as 400%, if you are not able to pay this loan then you put yourself into risk of incurring many different fees and fines, and eventually put you into a vicious debt trap. 

Although these loans do not require any collateral or security but, the lender will take a post-dated check from you which your lender will cash on the date mentioned on the check. So, you must see to that you have enough balance in your account to cover the amount on the check or else you may get into legal trouble.

Installment loans for bad credits

For a consumer with a bad credit score borrowing money via installment loans from reputed financial institutes like banks and credit unions is not that difficult as presumed. Financial institutes can give loans to person with bad credit score after scrutinizing the credit history. 

To understand your chances of getting an installment loan you should know how FICO credit score is calculated. Check below to know on which factors credit score is calculated and how much weightage each factor has,

1. Payment History – 35%: Your past payment history carries the most weight towards your credit score. In past payment history it is checked whether you have paid past credit dues and how timely are you paying your other dues and bills. This help lenders assess risk while lending you money. Late payments, defaults, bankruptcy and repossessions can affect this score.
2. Amounts Owed – 30%: Owing money on your credit accounts may imply towards low FICO score but it does not account you as a borrower who possess high risk. However, if your credit usage is too high from the available credit, then it is indication that you are thinly stretched. This can give an impression of you someone who is likely to default.
3. Length of Credit History – 15%: Long credit history will account towards better FICO scores so, it does not mean that people who have not been using credits for long period will not have good FICO scores, other factors also plays role and if rest of these factors are good then your FICO score will be good. FICO scores will look for age of all of your accounts and how period of usage of each account.
4. Credit Mix – 10%: Your other financial interactions like credit cards, retail accounts, loans, mortgages, etc. are also considered while calculating. But, it is not necessary for you to have all of these. A mix of different credits usage shows that you are a responsible borrower and possess less risk.
5. New Credit – 10%: Opening numerous credit accounts within a short amount of time represents a great risk and it is not good to open multiple credit accounts if your credit history is not old. It is observed that having numerous credits at a short time affects FICO scores.

If you are someone who has bad credit score but were well within the FICO guidelines then your chances of getting loan is good. Moreover, installment loans are not strict with the FICO score and they will review your loan file as per their policies too.

Banks and other finance unions just want to make sure that the money they are lending is not at risk and there is assuring that will get their money back. If you are able to show that then it likely that you will secure a loan.

How installment loans are best for bad credit?

As you have understood what bad credit, installment loans and payday loans are, you must have also understood the basic working of installment loans. What makes installment loans best choice is that you do not have to pay all of the amount with interest at a time, instead you pay the money at small fixed intervals. 

Another advantage of taking installment loans is you are borrowing from credible sources and it can also help improve your credit scores.

The interest rates charged for installment rates are low, you may see that you are not getting privileges like other borrowers with scores and you are paying higher interest rates but, if you compare the interest rates with payday loans you will realize that you are paying less. As mentioned in earlier section payday loans can have interest rate averaging at 400%.

When comparing with the alternative, payday loans, installment loans outshine in every aspect as it is less burdening on borrower, provides better interest rates and it can also be refinanced and, financial institute may also help with some exit option. Whereas, with payday loans repayment can become a burden as the money borrowed has to be paid with interest in lumpsum, interest rates are too high and eventually it can become a debt trap.

The only advantage a payday loans has over installment loans is that the loans are approved fast and does not require any hefty paper work.

If you are looking for some finance and way to improve credit score, consider personal installment loans. They are safe and less risky way to improve credit. 

You should also consider secured credit cards as another option to build your credit. For these types of cards, you will have to pay some upfront cash as security deposit which can be in few hundred dollars. These deposit requirements can help you get a secured credit card without consideration about your credit scores.