You will find the term “annual percentage rate” or APR commonly used in the world of finance. It is used in reference to financial products such as personal loans, credit cards and mortgages.
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What is APR?
The annual percentage rate (APR) of a loan is the amount of interest you have to pay each year that is represented as a percentage of the loan balance. This is paid to the investors by the borrowers as a percentage that represents the actual cost of funds annually over the term of a loan or income earned on an investment. This will include fees or any additional costs that are associated with the transaction. However, it will not take compounding into account. The APR basically provides consumers with a bottom-line number that can help them easily compare rates with other lenders.
How Does APR Work on a Loan?
An annual percentage rate is mainly expressed as an interest rate. It calculates the percentage of the principal you will be required to pay each year. This is done so by taking things such as monthly payments into account.
APR is the annual rate of interest that is paid on investments without taking into account the compounding of interest within that year.
It was mandated by 1968’s Truth in Lending Act (TILA) that lenders would disclose the APR that they charge to borrowers. Credit card companies can also advertise interest rates on a monthly basis. However, they are required to clearly report the APR to customers before an agreement is signed.
How to Calculate APR on a Mortgage?
The annual percentage rate is calculated by multiplying the periodic interest rate with the number of periods in a year in which the periodic rate is applied. However, it does not indicate the number of times the rate has been applied to the balance.
APR= [(fees+interest/principal)/n x 365] x 100
Interest = Total interest paid over the life of the loan.
Principal = Loan amount.
n = Number of days in loan term.
You can even use a simple APR calculator to calculate your annual percentage rate.
APR is typically presented as the periodic interest rate in the U.S. This is then multiplied by the number of compounding periods per year.
However, the definition of APR can differ outside of the U.S. The European union tends to focus more on consumer rights and financial transparency when defining this term. There was only a single formula established for calculating interest rate for all EU member nations. However, some countries tend to have some leeway when determining the exact situation in which this formula can be adopted above and beyond EU-stipulated cases.
How Does APR Work on a Personal Loan?
While shopping for a personal loan, the APR is an important thing to consider since it provides the nearest cost comparison. The interest rate or the monthly payment do not reflect the true cost of the product alone.
Personal loans are fixed-rate installment loans. This means that your interest rate will not change over the term of the loan and you will be required to pay back the loan in equal monthly installments. An interest rate is assigned to you by a lender based on your credit report, credit score and the ratio of debt to gross income.
There is usually an upfront fee attached to a personal loan, also known as the origination fee that can range from 1 percent to 6 percent of the loan amount. This fee that you will be charged will also depend on your credit profile.
You should try to shop around at multiple lenders since each lender has a different formula to calculate APR. Most online lenders will let you pre-qualify to check your estimated rate without your credit score getting affected.
Now look at how APR can help you choose a loan. Let’s suppose you want to borrow $5,000 and pay it back over a period of four years. You reach out to two lenders and are quoted the following rates:
Lender 1 | Lender 2 | |
Interest rate | 11% | 10% |
Origination fee | $100 (2% fee) | $150 (3%) |
Monthly payment | $132 | $131 |
APR | 12.1% | 11.6% |
Now, when you look at this table, it would be hard to tell which loan is cheaper. One lender can offer a low rate but charge a higher fee and the monthly payment rate can still be equal.
This is where APR comes in. Since the first loan has an APR of 12.1% and the second loan of 11.6%, the second is the less expensive option.
Now thanks to APR, you can compare the total cost of both the loans and choose one that is right for you. It is recommended to go for a loan that has the lowest APR for a given loan term since it is always the cheapest option.
In some cases, it can also make sense to choose a higher-interest-rate loan if you think the monthly payment is more affordable given your budget or if the origination fee is lower. Some lenders will deduct this fee upfront so you may end up getting less than the amount you are approved for, even if you are approved for a $5,000 loan.
How Does APR Work on a Mortgage?
APR can be complicated with a mortgage because it includes more than just your interest charges. Any quotes that you may get from a lender will include the closing costs that you will be required to pay.
Moreover, you may be required to make additional payments in order to qualify for the loan like private mortgage insurance. Lenders can decide whether or not certain items will be a part of the APR calculation so you would have to be careful and know how to do your own calculations.
It is important to know how long you will keep the loan in order to make the best decision. For example, even though one-time charges and upfront costs can drive up your immediate costs to borrow, APR will assume that those charges are spread out over the full term of your loan. Thus, as a result, the APR will seem lower on long-term loans. If you are planning on quickly paying off a loan, APR will typically underestimate the impact upfront costs will have.
How Does APR Work on Credit Cards?
APR can tell you the interest payments with credit cards. However, they would not include the effects of compounding interest so you end up paying more than the APR quoted.
You are likely to pay interest on the borrowed money and the interest that already has accrued if you carry a balance on your credit card. This compounding effect can make the cost of borrowing higher than you might expect.
Although the APR for credit cards will include interest costs, it will not include the other fees you pay to your credit card issuer which means you will have to research and compare those fees separately. It is likely for charges like balance transfer fees, annual fees and other charges to add up. As a result, a credit card that has a slightly higher APR might be better for you. However, it varies on how you use your card. Additionally, it is likely that your card has different APRs for different types of transactions.
How Does APR Work on Payday Loans?
Payday loans seem to have relatively low rates but the fees you have to pay make the overall cost of borrowing really high. However, the charges can be bearable sometimes. For example, you might not have a problem paying $15 to get cash quickly in an emergency. But if you look at these costs in terms of an APR, you may find that there are other ways to borrow that are less expensive than payday loans.
For example, if you took a $500 payday loan that has to be paid back within 14 days and has a $50 fee, the APR of the loan will be 260.71%. The Consumer Federation of America has given us a guideline on how to calculate it:
- Divide the finance charge by the loan amount. In this case, $50 will be divided by $500 equals 0.1.
- Then multiply the result by 365 to get 36.5.
- The result of that will then be divided by the term of the loan. In this case, 36.5 will be divided by 14 to get 2.6071.
- The result would then be divided by 100 in order to turn the answer into a percentage, resulting in an APR of 260.71%.
Conclusion
So now we know. How does APR work on a loan is fairly simple. You can either calculate the APR yourself or find a simple APR calculator that would crunch the numbers for you.
The APR can be a valuable tool when you are looking to find a way to compare personal loans. Once you understand the relationship APR has with interest rates, it can help you choose wisely when you shop for a loan that meets your budget and needs best.