What is Annual Percentage Rate (APR) and How it is Calculated?

Aug 17, 2020Other Loans

For most of us, the process to choose the right loan means choosing the lender that offers the lowest interest rates. But, the process is totally wrong and can cripple your finances in the long term.

By taking the advertised interest rate into account while calculating the interest cost, it fails to reflect the actual cost of borrowing. In fact, it is only the nominal interest rate and doesn't include other costs involved in taking the loan. Due to this reason, the final cost of loan comes out to be much higher than the advertised interest rates.

Therefore, following a standardised computation process, such as APR or Annual Percentage Rate helps you to know the actual cost of borrowing beforehand.

Let us understand what is APR and how it is calculated.

What is APR?

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The Annual Percentage Rate or APR helps you to calculate the actual borrowing cost over a particular period. It is expressed in percentage and represents the yearly cost of loan.

It takes into account the nominal interest rate and all other fees involved in getting and servicing the loan. The fees include processing fees, insurance costs, administrative costs and other miscellaneous expenses. However, it doesn't consider compounding into account while calculating the actual interest cost of the loan. 

The annual percentage rate will always be equal or higher than the nominal interest rate charged on loan. 

APR is a very useful tool in comparing the loan terms of different lenders and helps to find the right lender that suits your needs. 

How APR is Calculated?

The formula for calculating APR is:

APR= [{(Fees + Interest)/ Principal}/ n]*365*100

interest- total interest to be paid during the loan tenure

n- tenure of the loan in days

For example: Vijay wants to apply for a personal loan of Rs 5 lakh with repayment tenure of 3 years. The interest rate charged on the loan is 12% and the processing fee is 1.5% and insurance cost is Rs 4,700. The APR of the loan will be calculated as follows:

The processing fee is coming at Rs 7,500 and total fee including insurance cost is Rs 12,200. And, the interest cost is Rs 1,80,000.

APR = [{(12,200+1,80,000)/5,00,000}/1095]*365*100 = 12.81%

The actual cost of loan is coming at 12.81% for the 3 years loan tenure and is higher than the nominal interest rate. 

Like every other financial metrics, APR too has few shortcomings such as it doesn't work with floating interest rate and is not suitable for comparing short-duration loans. 

Why is APR important?

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When it comes to knowing the true cost of borrowing, the annual interest rate (AIR) advertised by lenders fails to reveal the true cost of the loan. And, lenders in order to attract customers deliberately keep the AIR lower and keep all other charges high. Thus hiding the actual cost of the loan.

APR is very useful while taking a mortgage loan like a loan against property. As the loan tenures goes up to 20 years and the list of documents required for loan against property, verification and appraisal of the loan application is substantial, it often translates into higher processing fee and administrative costs.

Bottom Line

Using the annual percentage rate not only gives you a better idea on the cost of a loan beforehand, but also helps you to choose the lender wisely and get the best loan deals. 

Therefore, whenever you apply for a loan, make sure you confirm the APR with your lender before signing the loan documents.

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