The annual percentage rate, or APR, is an important concept for anyone using loans and credit. This blog explains what the APR is, how it is calculated, the difference between interest rates and why knowing the APR helps compare financial product costs effectively.
What is Annual Percentage Rate?
Annual percentage rate or APR is the actual cost of a loan expressed as a yearly rate. It includes interest plus other fees and charges. Knowing the APR allows you to compare loan offers and understand the total cost over the life of the loan.
Example
For example, if you take a personal loan of Rs. 100,000 with 10% interest and a 2% processing fee, the nominal interest would be Rs. 10,000 per year. However, the APR is higher at 12%, as it also includes the processing fee. The APR gives a true sense of how much the loan will cost.
How the Annual Percentage Rate Works?
The annual percentage rate or APR is a value that expresses the yearly total cost of a loan as a single percentage number. It incorporates the agreed interest rate plus other charges to give a complete picture of loan expenses each year.
How is the Annual Percentage Rate Calculated?
The annual percentage rate (APR) shows the actual cost over the year. It’s calculated using a formula incorporating interest, fees and the loan period.
Example with Calculated
For example, with a ₹100,000 loan at 10% interest charged monthly and ₹2,000 processing fee, the interest per year is ₹10,000 and fees ₹2,000. Add these and divide by the loan amount (₹100,000+₹2,000), then multiply by several days (usually 365) and divide by the number of days in the loan term. Plugging into the formula – APR = ((₹10,000 + ₹2,000) / ₹100,000) x (365/365)) x 100 = 12%. So, the APR of 12% accounts for all annual costs, higher than the nominal 10% interest rate.
Different Types of Annual Percentage Rate
Here are the Types of APR:
1. Variable Annual Percentage Rate
Some loans offer an APR that can change over the loan’s lifetime to changes in an index rate. Variable APR loans may start at a lower interest rate than fixed loans but come with risk as future rates rise, meaning monthly payments fluctuate along with them. This type gives less long-term certainty.
2. Fixed Annual Percentage Rate
With this variety, the disclosed APR at the beginning of the loan remains steady for its full term regardless of market changes. Monthly instalments stay constant, giving greater budgeting ease. However, the interest rate may be higher compared to the variable at origination to offset the stability.
What is the Annual percentage yield?
The annual percentage yield, or APY, takes interest rates and compounds them over the year. It reflects the actual return your money would earn if interest was added back each period and compounded annually for products like savings accounts.
Difference Between APR & Annual Percentage Yield
| APR | Annual Percentage Yield |
|---|---|
| Represents the annual cost of a loan | Takes interest rates and factors in compounding to show actual yearly return |
| Required to be disclosed for loans | Often disclosed for investment products like savings accounts |
| It does not account for the compounding of interest | It gives a more accurate picture of growth as it incorporates compounding |
| It tends to be lower than APY | It tends to be higher than APR as it accounts for compounded growth |
What is the Interest Rate?
The interest rate is the percentage charged by the lender for the use of borrowed money, usually expressed as an annual percentage of the loan’s principal.
Difference Between Interest Rate & APR
The annual percentage yield, or APY, takes interest rates and compounds them
| Interest Rate | APR |
|---|---|
| Refers only to the primary interest charge | Includes interest rate plus additional fees and charges associated with the loan |
| Does not present a complete picture of loan cost | Provides a single value for total annual cost of borrowing |
What is the Nominal Interest Rate & Daily Periodic Rate?
- Nominal interest rate: The nominal interest rate is the rate at which interest is charged on the principal amount of a loan or deposit.
- Daily periodic rate: The nominal interest rate is divided by 365 days or 366 in a leap year, charged daily on the outstanding balance.
Difference Between APR & Nominal Interest Rate
Here is the difference between APR & nominal interest rate
| APR | Nominal Interest Rate |
|---|---|
| Takes into account all interest and fees associated with the loan over its lifetime | Refers only to the primary annual interest charged on the principal amount |
| Higher than nominal interest rate as it incorporates additional costs | It does not include fees charged on the loan and, therefore, is lower than the APR |
| Expresses the total annual cost as one percentage value | Shows only the essential yearly interest charged and not the total annual cost |
Differences Between APR & Daily Periodic Rate
| APR | Daily Periodic Rate |
|---|---|
| Provides borrowers with the total annual cost of funds as one figure | Not the entire yearly cost figure, but instead used to calculate daily interest |
| Incorporates interest rate as well as other loan-related fees | Derived from nominal interest rate divided by the number of days in a year |
| A single percentage value for easy comparison of loan costs | Applied to outstanding principal balance to determine interest charged daily |
| Benchmark for Truth In Lending disclosures | Used with the principal balance to compute interest amount daily |
Why Is the Annual Percentage Rate (APR) Disclosed?
Lenders must disclose the APR so customers can easily compare the actual costs of different loans. Using only the interest rate hides additional fees and fails to show the total yearly cost of borrowing money. The APR creates transparency around hidden charges in long-term loans.
Why is the Annual Percentage Rate (APR) Higher Than the Interest Rate?
The APR usually exceeds the nominal interest rate since it accounts for various extra fees in a loan besides interest. These fees increase the annual cost of the borrowing expressed through the higher APR percentage versus what the interest rate solely reflects.
Can APR be Equal to or Less Than the Interest Rate?
It is rare for the APR ever to be equal to or less than the interest rate alone since the APR absorbs additional costs on top of the interest. A loan devoid of hidden fees and charges beyond pure interest payable would be required for the APR and interest rate to align.
Does 0% APR Mean No Interest?
While 0% APR sounds attractive, other costs may still be involved. Many 0% deals last only for an introductory period before switching to a higher rate if the balance is not cleared. Fees can also be charged on purchases or late/missed payments, so checking all terms and conditions is best.
What is APR on a Credit Card?
The APR on a credit card indicates the total annual cost of using the card and carrying a balance. It includes interest that is charged as well as annual and other fees. Knowing the APR makes it easier to compare credit cards and understand the actual expense of any unpaid balances over an extended period.
What is a Good & Bad APR for a Credit Card?
Here are good and bad APR for credit cards:
1. Good APR
- Below 20% APR is generally considered suitable for a credit card.
- It allows carrying a balance without heavy interest costs if paid on time.
- Offers a low-cost option for short-term needs like purchases spread over billing cycles.
2. Bad APR
- Over 25% APR means high-interest charges for unpaid balances.
- It can rapidly accumulate to exceed initial spend amounts the more the card is used.
- Unless paid in full monthly, a high APR risks putting users in financial difficulty over time.
How to lower your APR on a Credit Card?
If you find yourself paying a high-interest rate on your credit card balances each month, do not despair. There are some steps you can take to try and secure a lower APR. Taking action to improve your creditworthiness over time is critical.
- Ask your current credit card issuer for a reduced rate. Be polite and explain your positive payment history and longstanding relationship. Request a lower rate due to financial hardship.
- Transfer your balance to a credit card offering a promotional 0% APR period. Carefully read all terms and ensure you can pay off the entire balance before the intro rate expires.
- Apply for a new credit card with a lower ongoing APR. Check rates offered by other banks or credit unions. Always check if there is an annual or balance transfer fee first.
- Improve your credit score by paying all bills on time. Being declined for a reduced rate can further hurt your score, so only apply if you are confident you qualify.
- Consulting a nonprofit credit counselling agency can help negotiate with creditors on your behalf. This remains on your credit report for seven years.
What is Refers to Good & Bad APR?
1. Characteristics of Good APR
- Below 15% is considered a reasonable rate
- Rates around 10% or less are very reasonable
- The national average is around 16%, so anything below that is good
- Interest costs will be reasonably priced, paying over time
2. Characteristics of Bad APR
- Over 25% is an unacceptably high rate
- Rates from 20-25% are still on the expensive side
- It will cost a lot in interest charges
- Try to get a lower rate card ASAP if you are stuck with a bad one
- Consider balance transfer to save on finance costs
- Have a plan to pay off the card fully if the rate is high
Importance of Annual Percentage Rate
The annual percentage rate, also known as APR, provides critical information about the total cost of credit. Understanding the APR is vital for borrowers to evaluate different loan options effectively.
- APR reflects the actual cost of credit by incorporating interest rates and fees into a single percentage value.
- It allows for an apple-to-apple comparison of loan offers, even with different terms or fee structures.
- Borrowers can avoid costly surprises by ensuring the quoted APR matches the advertised or discussed rate.
- Lower APR translates to paying less total interest over the life of a loan and more money in the pocket in the long run.
Characteristics & Features of Annual Percentage Rate
Here are the Characteristics & features of the annual percentage rate:
1. Characteristics
The APR encapsulates critical characteristics of a loan’s cost in a single value. It reflects the annual cost of credit through interest rates and fees as a percentage of the loan amount. Understanding the characteristics of the APR is essential for consumers.
- Represents the annual cost of credit as a percentage of the loan amount, not just the interest rate.
- Incorporates interest, origination fees, and additional charges into a single percentage value.
2. Features
Knowing the features of the APR helps borrowers identify essential aspects to consider when reviewing loan offers. The APR allows for transparent evaluation of different credit products.
- It makes it easy to compare loan options even if they have different terms, interest rates or fee structures.
- Standardizes cost of credit comparisons regardless of the loan details or financial institution.
- It enables borrowers to determine the actual annual cost of loans and avoid unfavourable offers.
Advantages & Disadvantages of Annual Percentage Rate
Here are the Advantages & disadvantages of APR:
1. Advantages
By understanding the advantages of APR, borrowers can utilize it as a helpful tool when assessing financing options. The APR assists consumers in making informed choices.
- Provides a simple, transparent view of the total cost of credit over time.
- Allows easy comparison between loans with different terms, fees or interest rates.
- It helps identify the most affordable offers and avoid costly pitfalls.
2. Disadvantages
While useful, the APR has some potential limitations that consumers should know. Recognizing disadvantages is important for getting the whole picture.
- Does not show repayment amounts or loan payoff timeframes.
- Fluctuating interest rates affect it, but rates can change after origination.
- Fees are excluded if below a minimal threshold, distorting the actual cost slightly.
Final Word
The APR incorporates multiple costs to show the yearly expense of taking and repaying a loan or carrying a balance on products like credit cards. Being aware of the APR helps make informed borrowing decisions to avoid unnecessary charges and stay within budget over the long term.
FAQs
To calculate APR, you would take the total interest and fees charged for the loan divided by the loan amount and multiply that by the number of days in the loan term.
The actual APR accounts for the true annual cost of credit over time, including compounded interest and additional amounts like origination fees that get factored into repayment.
The interest rate only shows the percentage charged for using loaned money, whereas APR incorporates interest plus all applicable fees for a more complete picture of the total cost.
Disclaimer
This article is solely for educational purposes. Stable Money doesn't take any responsibility for the information or claims made in the blog.
