Financial Planning -> Save Money -> Know the interest rate
Make sure you know the interest rate before committing to a loan
In some provinces, lenders are required under provincial consumer protection laws to disclose both the total cost of credit and the annual percentage rate (APR). The total cost of credit includes additional finance charges such as application, administration and service charges.
In BC, the calculation method for the APR is defined in the Business Practices and Consumer Protection Act Disclosure of the Cost of Consumer Credit Regulation.
In Ontario, the calculation method is defined in the Consumer Protection Act, 2002, Ontario Regulation 17/05, s. 55.
APR using average principal outstanding calculated from amortization table
The APR (for credit agreements other than leases) is defined in both the BC and Ontario regulations, when all interest calculation periods under the credit agreement are of equal lengths, as:
[C ÷ (T × A)] × 100
If you have an amortization table of your loan, you can use it to calculate the average principal amount outstanding exactly, instead of using our method for estimating the average. To calculate the average principal, calculate the sum of:
- for each calculation period in the term of the loan, the outstanding principal amount before any payment is applied.
Then, divide this sum by the number of calculation periods in the term of the loan.
Example using information from a purchase of a 5 year old vehicle from a used car dealership in BC (numbers are approximate):
*We are told that there was actually no down payment, although the sales document showed one. Apparently this was "paid by the dealership", in other words, the price was reduced. However, there was no corresponding reduction in sales taxes.
The interest rate was not stated on the sale document, so it was calculated using the factors of loan amount, term and payment amount, and an amortization table was produced. This allowed calculation of the total interest cost (which was stated on the sale document). The total interest cost and the finance fee are added together to get the total cost of credit. This leaves a "loan" amount of $14,045 excluding the cost of credit. Here is what we determined by our calculations/amortization table using an Excel workbook, and amortizing the $14,045 loan over 54 months:
APR using estimated average principal outstanding
It is fairly easy to do an estimate of the APR that you are being charged. You need to know
It's important to realize that over the term of any loan which is repaid with equal payments paid at regular intervals, the average principal amount outstanding on the loan is approximately (actually slightly more than) half of the loan amount. To estimate the average, add together the beginning loan amount and the payment amount, and divide by two.
This results in an estimated APR of 30.3% ($10,212 divided by ($7,497 x 4.5)), which is significantly higher than the actual APR.
As you can see, the resulting interest rate is lower when using the exact method of calculating the average outstanding principal. The difference between the two methods becomes greater as the term of the loan becomes longer and the interest rate becomes higher.
See also: Buying a Vehicle
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Tax tip: Make sure you know the APR you are being charged, and explore other financing options.
Revised: March 06, 2021
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