The annual Percentage Rate (APR) represents the annual cost of your loan in percentage.
Any personal loan would cost you interest, processing charges, and any other associated fees. APR accounts for every costs and tells you what is your actual cost of funds.
APR is an effective to compare between multiple lenders. Lenders with lower APR is the cheapest option for the borrowers.
For example, imagine you are considering taking out a personal loan of $10,000. Two lenders offer you different interest rates and fees. Here’s how you can compare them using APR:
You have two options as follows:
- Lender A: (Option 1)
- Interest Rate: 5%
- Origination Fee: $200
- Loan Term: 3 years
- Lender B: (Option 2)
- Interest Rate: 4.5%
- Origination Fee: $400
- Loan Term: 3 years
Calculating APR:
- Lender A:
- Interest: $10,000 * 5% = $500 annually
- Origination Fee: $200
- Total Cost for Year 1: $500 (interest) + $200 (fee) = $700
- APR = (Total Cost / Loan Amount) * 100 = ($700 / $10,000) * 100 = 7%
- Lender B:
- Interest: $10,000 * 4.5% = $450 annually
- Origination Fee: $400
- Total Cost for Year 1: $450 (interest) + $400 (fee) = $850
- APR = (Total Cost / Loan Amount) * 100 = ($850 / $10,000) * 100 = 8.5%
What’s the decision factor?
- Even though Lender B has a lower interest rate (4.5% vs. 5%), the higher origination fee results in a higher APR (8.5% vs. 7%).
- APR provides a more comprehensive measure of the loan’s cost, making it easier to compare the true cost of loans from different lenders.
APR Calculator
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How APR works?
APR calculates the effective cost of the borrower that you are going to incur for any particular loan each year.
APR effectively works as a comparison tool when you have multiple lending options with a diversity of associated fees and interest rates.
However, disclosing the actual cost of borrowing is necessary for the lenders per the Truth in Lending Act (TILA), 1968.
For example, as per the previous scenario comparisons between two lenders helped the borrower to choose the cheapest loan. However, the banks, usually need to disclose what is the actual cost of borrowing to the clients.
This is the reason, banks and other financial institutions make advertisements at a nominal rate of interest and put a detailed calculation of the cost of borrowing in the loan agreement or sanction letter.
Per the TILA, financers disclose the true cost of borrowings and the borrowers acknowledge with a signature.
It also effect bank’s upcoming changes of interest rates.
For example, if your lender is going to revise the interest rate on a revolving loan or on a credit card, the lender needs to publish a 45-day prior notice before the change affects your future transactions.
Keep in mind, that no bank can make any retrospective effect on your past balance by implementing a revised interest rate. Most of the Core Banking Systems (CBS) such as Oracle, Finacle, or Ababil are designed in this way to adhere to all the rules and regulations.
How many types of APRs are there?
There are different types of APR such as fixed, variable, introductory, penalty, and cash advance APR.
A fixed APR remains the same throughout the tenure of that type of loan. For example, If you take a personal loan with a 9% fixed APR, it will remain the same during the agreed tenure of your borrowing. A fixed APR is suitable if you want stability and predictability.
A variable APR can change over time, typically based on an underlying index like the prime rate or LIBOR. For example, a credit card with a 10% variable APR might increase or decrease in response to changes in the prime rate. However, the change in APR must require 45 days prior notice as per the rules.
An introductory APR is a temporary, lower rate offered at the beginning of a loan or credit card agreement. After the promotional period ends, the APR increases to the standard rate. For example, a credit card might offer you ZERO APR in the first 1 year but the interest rate of 18% would be applied on the subsequent years. This is a promotional strategy of the lenders that creates a habit on a particular loan scheme.
Penalty APR represents the original APR plus any additional penal interests. For example, if you own a credit card that requires 18% interest, it may become 29% if you miss out on any scheduled payment. Similarly, credit card companies offer cash withdrawal facilities for up to a certain percentage of your usage limit. And, the cash withdrawal will face usually a bigger amount of interest.
Are APR and Annual Percentage Yield (APY) the same?
No. APR and APY are different.
APR represents the annual cost of your borrowing or the annual earnings of any investment. On the flip side, the Annual Percentage Yield of APY accounts for the real rate of return earned on a particular savings for an aggregated period.
APR does not account compounding of interest and it simply annualizes the interest rates and other associated costs over 1 year.
However, APY includes a compounding effect for better accuracy of the total interest earned.
APR is commonly used for loans, credit cards, and mortgages. However, the APY is typically used for savings accounts, certificates of deposit (CDs), and other interest-bearing accounts.
While calculating the APR, interest and other fees are added and then the figure is divided by 365.
APR = [(Interest + Fees) / Principal] / Number of Days in Loan Term * 365
However, APY accounts for the time value of money by compounding the nominal interest rates.
APY = (1 + r/n)^(n*t) – 1.
So, the key differences arise from:
- Interest and compounding (APY accounts compounding and APR doesn’t)
- Usage perspective (APR is used by the borrowers and the APY is used by the investors)
- Different calculation method (nominal interest is compounded in APY)
Let me show you another example that will help you understand the use of APR and APY.
Let’s say that you take out a $10,000 personal loan with a 5% nominal interest rate and a $200 origination fee. The loan repayment period is one year.
So, the APR would be:
(Total cost/principle) x 100 or, ((500+200)/10,000) x 100
APR is: 7%
Now think that you are investing 10,000 in a savings account for one year. The interest rate is 5% nominal but compounded monthly.
In such case, your monthly interest rate is: 5%/12 = 0.4167%
APY would be:
(1 + r/n)^(n*t) – 1 or,
(1+120.05)12−1=(1+0.004167)12−1≈0.0512 or 5.12%
In a nutshell, APY tells you the actual return made from any investment where the interest rate is compounded over the months or years. On the other hand, the APR tells a single story what is your cost of borrowing for one year.
How does APR differ from the nominal interest?
Nominal interest represents the interest percentage that lenders ask for the borrowed amount.
APR accounts for nominal interest plus other associated costs of borrowing such as loan processing fees, insurance, and closing costs, etc.
In a nutshell, APR considers all costs including nominal interest as well, and tells you a percentage figure to summarize the net cost of borrowing.
Let’s say, you take a $10,000 loan with a nominal interest rate of 5%, a $200 origination fee, and a one-year term.
Your APr would be 7% by performing calculations like we showed previously.
The 7% represents a combination of nominal interest of 5% plus other costs of $200 origination fee.
So, how would you calculate a daily APR?
Daily or periodic cost of borrowing is easy. Simply divide your APR by 365 and multiply by your required day.
If your APR is 7% and you are looking for borrowing cost (%) for one week, it would be 7/365 x 7 or 0.134%.
So the main differences between nominal interest and APR are:
| Aspect | APR (Annual Percentage Rate) | Nominal Interest Rate |
|---|---|---|
| Definition | The total annual cost of borrowing, including interest and fees | The basic interest rate charged without any additional fees |
| Includes Fees | Yes, includes fees and other costs | No, only the interest rate |
| Reflects True Cost | Yes, provides a comprehensive view of borrowing cost | No, does not account for additional costs |
| Compounding | Can account for compounding but not always | Does not account for compounding |
| Transparency | More transparent, easier to compare different loans | Less transparent, may not reveal all borrowing costs |
| Calculation Complexity | More complex, includes fees and compounding effects | Simple, based solely on the interest rate |
| Impact of Payment Timing | Can reflect the impact of different payment schedules | Does not consider payment timing |
| Regulation | Often regulated to ensure consumer protection | Less regulated, more straightforward |
Moreover, a secured loan comes with a lower APR since there are fewer risks attached to the lender. So, if you are offering any collateral to the lenders. Make sure that your annual borrowing cost is less than the unsecured loan’s APR.
What is the limitation of APR?
APR is a useful tool to determine the actual cost of borrowing so that lenders can compare different options.
However, the APR does have some negative sides.
APR only accounts for fees that are disclosed in the loan agreement. It does not consider any other fees that arise later. For example, the late payment fees are not reflected on the APR calculation as the borrower is not sure about how many times will he miss out on the monthly EMI.
Subsequently, It will be impossible to utilize this tool while determining the impact of variation of grace period and penal interests.
During the APR calculation, we only consider a fixed rate of nominal interest but in real, a loan may have a variable interest rate that is not reflected on the methodology.
APR does not consider the complexity of loans. For example, borrowings with deferred interest or introductory rates with balloon payments are not reflected in the APR calculation.
For example, a credit card offers 0% APR for the first 12 months, then 20% APR afterward. The initial APR might appear attractive, but the long-term cost can be much higher.
Furthermore, during the APR calculation, we assume a fixed loan tenure but, it ignores the possibility of early settlements and potential savings on borrowing costs.
Lastly, APR does not consider inflation or the time value of money. We all know that today’s $100’s value would not be similar to $100 after 9 months.
How to determine if APR is in the acceptable range?
APR is a tool to determine annual loan costs that need other judgment too. Undoubtedly, it offers a base for comparing similar offers but you should consider the below things before considering an APR as a suitable option.
Before choosing, you should observe the market trend and compare your borrowing cost with the other similar percentages. Some websites such as Bankrate or Investopedia have historical data with long-standing statistics. That should be a starting point to compare your initial cost of borrowing.
Observe your credit score. Your APR should be low if you have a credit score of 750+.
Here’s a table that shows the change in APR with the change in credit score:
| Credit Score Range | Personal Loan APR (%) | Credit Card APR (%) |
|---|---|---|
| 720 – 850 (Excellent) | 6% – 8% | 13% – 16% |
| 690 – 719 (Good) | 9% – 12% | 16% – 19% |
| 630 – 689 (Fair) | 13% – 18% | 19% – 23% |
| 300 – 629 (Poor) | 19% – 36% | 24% – 30% |
Conclusion
In summary, APR is a theoretical measurement to determine the annual cost of borrowing. Even though there are some limitations such as the inability to account for uncertain fees or complex loan structure, APR can be a very good starting point to compare the different borrowing options.
