The Annual Percentage Rate (APR) of a loan or line of credit is the total amount of interest payable on the loan per year. The APR is calculated as a percentage of the loan balance and is taken before the compounding of interest.
Apart from the interest, APR includes other costs involved in the procurement of a loan. Examples of such costs include broker fees, discount points, rebates (also known as lender credit), and much more. APR serves as the summary number that borrowers can use to make comparisons among loan rates from different lenders.
How Does Annual Percentage Rate Work?
The APR discloses the percentage of the loan principal that you have to pay on an annual basis. It takes into account your monthly interest payment plus other loan expenses payable monthly.
The Financial Consumer Agency of Canada requires lenders to clearly specify the terms of a loan to the borrower before an agreement is reached. This includes the APR. Since the APR gives an overview of the payment of a loan, consumers use it as a basis for choosing their lenders and other loan modalities.
Why Is APR Important?
When getting a loan, the APR helps you understand what exactly you are going to pay back. Interest rates only may not give a holistic view because there may be other charges inherent in the low.
With APR, you are able to know the exact cost of getting a loan. This helps you make better-informed decisions on how to manage and pay back your loans. However, you may still need to consider other factors such as monthly payment, the credibility of the loan giver, and more before applying for a loan.
What Is the Formula for APR?
The formula for calculating APR requires only three figures: the amount borrowed, the total charges, and the number of days in the loan term.
The formula is as follows:
APR = ((((Fees + interest paid across the life of a loan) ÷ Loan amount) / number of days in loan term) x 365) x 100).
To break down the formula:
- Add the fees to the interest spread across the loan.
- Divide the result by the loan amount.
- Divide the result by the loan term (in days).
- Multiply the answer by the number of days per annum.
- Multiply the final result by 100 to convert it to percentage.
How Is APR Calculated?
Typically, lenders calculate the APR of your loan by adding the margin charged by the lender to an index such as the prime rate. The total amount is the APR.
For instance, if the prime rate is 5% and the lender’s margin is 10%, your APR becomes 15%. To calculate the Daily Percentage Rate (DPR), divide the APR by the number of billing days in a year (say 365 days). In this case, the DPR will be 15%/365 which equals 0.0004.
What Is an Example of APR?
Assume you take a loan of $50,000 for one year (365 days) with a charge of $2000. To keep the calculation simple, the APR will be calculated thus:
APR = (((2,000 / 50,000) / 365) x 365) x 100
Therefore, the APR here is 4%.
What Is a Good APR?
What is considered good for an APR may depend on the type of loan in question, and the credit of the borrower. Generally, a good APR is one below the current average interest rate.
The interest rate available to a borrower may depend on their credit. Applicants with excellent credit usually get the lowest interest rate and vice versa. According to the Federal Reserve, the average APR for U.S credit cards ranges from 14% and 15%.
Type of Annual Percentage Rate (APR)
There are different types of APR. The type of APR that applies to your credit card may depend on how you use your card. It is a good practice to consider these rates before you choose a credit card. The types of APR include:
Purchase APR
This is the common type of APR that applies to most credit card purchases. It applies to you if you usually make online purchases or bill payments with your credit cards.
Balance Transfer APR
This is the rate you get to pay on a debt you transferred to your credit card. It is possible to start with a promotional rate and deal with a rate increase at a later time. You might also have to pay a balance transfer fee.
Introductory APR
This is an APR you might get at a promotional rate because you are a new customer. Introductory APRs typically last for a limited time, usually attached to an expiry date. After the expiration, the rate eventually rises.
Cash Advance APR
This is the APR you are charged for borrowing money from your credit card. Cash Advance APR is relatively high, and you may still be charged a separate cash advance fee.
Penalty APR
This APR applies to you when you violate the terms and conditions of your credit card. When you fail to make payments on time, there is usually an increase in your APR. However, you can mitigate the effect of a penalty APR by making a series of on-time payments.
Annual Percentage Rate (APR) vs Annual Percentage Yield (APY)
Annual Percentage Rate only applies to the loan with regards to the simple interest. On the contrary, the Annual Percentage Yield (APY) takes the compound interest into account. This means that the principal with which the APR is calculated is different from the one with which you calculate the APY.
Because APY uses the compound interest, the principal used in the calculation is usually higher than the one used for APR. This implication is that the APY of a loan is usually higher than the APR. The higher the interest rate, the greater the difference between the APR and the APY.
APR vs Nominal Interest Rate
The nominal interest rate of a loan does not take other possible loan expenses such as rebates and broker fees into account. Nominal interest calculates only the percentage of the principal a borrower has to pay without adding any other cost to it.
On the other hand, APR accounts for these other expenses. This is to say that APR is nominal interest plus other possible expenses/costs. As a result, the APR is mostly greater than the nominal interest rate.
APR vs Daily Periodic Rate
While APR accounts for the interest rate on an annual basis, Daily Periodic Rate represents the rate of interest daily. Thus, you get the DPR when you divide the APR by the number of days in a year. Lenders may also opt for monthly representation of APR provided that they list out the full 12-month APR.
Disadvantages of APR
Inasmuch as the APR provides a good view of the cost of borrowing, it may not always be the best way to represent the cost. In the actual sense, APR may downplay the exact cost of borrowing.
For instance, comparisons between similar products from different companies may be difficult with APR estimates. This is because apart from the interest rate, the extra loan costs added to APR may differ across different organizations.
Companies reserve to a large extent, the right to how to calculate their APR by determining the fees applicable to the APR. This means that a company’s APR may be higher or lower than that of another because of the difference in the mode of calculation.
To be able to balance the comparison between multiple products, a borrower needs to ascertain the fees and costs included in the APR. Neglecting this may result in an imbalance and may affect the effectiveness of the borrower’s decision or preference.
Let us consider some other ways in which the APR can become detrimental in the assessment of loan borrowing costs.
Costs and Fees
APR spreads costs and payments over a long period of time. As such, the impact of some costs and fees may be understated because they are stretched out. If you calculate the same loan within shorter timeframes, the impact of the costs and fees may come out more significant.
An example is the closing costs of a mortgage. If you spread the cost over 20 years, the average annual impact will be smaller than when you spread it for just 5 years.
Difficulty With Adjustable-Rate Mortgages (ARM)
There is usually a difficulty with APR in Adjustable-Rate Mortgages. The assumption of a constant rate implies that although APR takes rate caps into consideration, the final output is still based on fixed rates.
After the duration of the fixed-rate, the interest rate on an ARM becomes uncertain. If there is a rise in mortgage rates later in time, the APR estimates will become an understatement of the cost of borrowing.
Bottom Line
Before you take a loan or any line of credit, it is important you understand the actual costs of the borrowing and the rates involved. Using the APR, you do not just get to understand how much interest you are meant to pay, but also the impact of other costs on your loan.
Miscalculation of APR may affect your assessment of the loan costs and as such, you may need the services of a Financial Advisor to ensure accuracy.