The Annual Percentage Rate (APR) is the amount of interest expressed as a yearly rate, including fees. Learn here how an APR works on a loan and how to calculate it.
Why Understanding APR (Annual Percentage Rate) is Important
The term APR, or Annual Percentage Rate, is an important term to understand not only when getting a credit card, but also when you are applying for a personal loan. Understanding how it is calculated and applied can help you make informed decisions when you need to borrow money. As a consumer, you may be able to obtain a low APR by building and establishing good credit.
It is also good to know what the Annual Percentage Rate is composed of before closing the deal, especially which fees are included. These numbers are also necessary to figure out your APR.
How to Calculate APR
Calculating APR is simple. You will need a few numbers to get started:
- Loan amount
- Interest paid over the life of the loan
- Number of days in the loan term
To help illustrate, let us calculate the APR on a $10,000 loan with a total charge of $4,000, which includes interest over the life of the loan and the origination fee. Additionally, let us assume the loan term is 5 years or 1,825 days.
|Steps to Calculating APR on a Loan|
|Step 1||Divide the finance charge by the loan amount.||$4,000 / $10,000 = 0.4|
|Step 2||Multiply the result by the number of days in the year.||0.4 x 365 days = 146|
|Step 3||Divide the total by the term of the loan.||146 / 1,825 days = 0.08|
|Step 4||Multiply the result by 100 and add a percentage sign.||0.08 x 100 = 8% APR|
APR vs Interest Rates
An APR is an annual cost you will pay on a loan including the origination fee. An interest rate, on the other hand, is the cost of borrowing the principal loan amount and can be variable or fixed depending on the type of loan. While both are expressed as percentage rates, the APR is the true cost of credit and includes applicable fees. Also, interest rates are often a monthly or even daily fee, contrary to the Annual Percentage Rate.
Learning about interest rates also lays the foundation for understanding the difference between Nominal APR and Effective Annual Percentage Rate (EAPR or EAR), also called Annual Percentage Yield (APY).
Nominal APR vs. Effective APR
Nominal APR is the simple interest rate, while Effective APR also considers compound interest. So, if you want to validate different lenders, loans, or credit cards, it is important to make sure what you compare.
In fact, most credit cards frequently compound interest, even on a daily basis. Hence, when evaluating different financing options, it is not only important to take a potential EAR into account but also to have a look at the determination of interest rates.
Personal Loan APR
A personal loan APR is fixed, which means your interest rate will not change over the term of the loan, and you will pay the loan back in equal, monthly installments. This differs from credit card issuers that calculate APR using an index rate such as the prime rate. That rate can either be variable or the London Interbank Offered Rate (LIBOR). A variable interest rate on a credit card could cause your interest rate to change, making your monthly payment harder to predict.
If you have any questions, visit the Best Egg resources page to learn more about loans, interest, and other financial education topics.