What is APR? Calculate APR
You may have noticed term ‘APR’ on different bank documents like mortgage statements, loan statements and credit card documents. The most common APR which one can see is credit card APR on monthly statements. Knowing what APR is, how it is calculated and how it is used, will help you make better decisions about your credit cards, loans and mortgages.
What is APR?
APR or annual percentage rate is an representation of interest rate on annual basis. In simple words APR is cost of borrowing money from bank or any financial institute for period of one year.
Annual percentage rate considers different costs associated with borrowing like, closing fees, administrative fees, late fees, etc. This makes APR one of the good method to calculate the cost of borrowing.
But, annual percentage rate does not consider the compounding of interest wherever it may apply.
APR is also used to compare costs of different loans and credits which may be available by different lenders.
Working of APR
Let us consider example of credit cards to explain working of APR. When you purchase a credit card, the credit card company will provide you with some benefits over the spending done with the card.
When you spend using your credit card you have to pay back the spent amount within the given due date, doing so will you will not incur any interest. You also have option to carry forward the balance on which interest is charged. Along with this interest there is something called as card fees which is charged annually and if you are late in paying the dues then you maybe charged with additional charges.
These additional charges, card fees and interest cumulated over a year are part of APR.
Types of APR
There are two types of APR: Fixed APR and Variable APR.
- Fixed APR: When you are under fixed APR, the interest rate applied to principal amount of the loan or spent amount via credit card does not change. Also, the APR calculated is fixed which is calculated as per the fixed interest rate. If you have fixed APR then the amount which you will be paying every year will not change.
- Variable APR: A variable APR will keep changing because the interest which is put on the principal amount changes over time. These interest rates are dependent on the changes in the lending rates. So, if there is increase in your interest rate then, your APR will also increase.
If your APR is high then, you may end up paying more to the lenders via paying more interest on the remaining balance. But, if you repay the borrowed money on time then you would not be charged with APR. The reason for APR not being charged is for the fact that the APR is calculated on the basis of balance amount left. So, if you pay the balance amount in full and within time then the APR will not be applicable to you.
How to calculate APR?
To calculate APR of your loan you must know your principal amount, period of your loan and any extra costs additional to your interest.
Calculating APR is a simple process, just follow the steps below:
- Calculate the interest rate of your loan
- Add additional fees associated with your loan to the interest
- Divide the above calculated amount with principal amount of your loan and its period.
- Multiply the number you get with 100.
Formula of APR:
APR = (Interest +Fees)*100/(Principal Amount + Period of the loan)
Consider below example to understand how APR is calculated:
John borrows $5000 at am interest rate of 7% per annum for 3 years which is not compounded. The bank is charging $300 as administrative cost over the loan.
Before calculating John’s APR we will have to calculate his interest on the borrowed money.
To calculate interest, we are using simple interest formula that is: A = (P(1 + (r*t))), where A is the total amount, P is principal amount, r is interest rate of the loan and t is time period for which the loan is borrowed.
So, John after 3 years John will have to return (5000 (1 + (0.07*3))) that is $6050.
Hence, the interest for 3 years will be $6050 – $5000 = $1050. i.e. John has to pay additional $1050 over $5000 which he has borrowed. This additional money does not include other costs like administration fees.
Now, we will add administrative fees of $300 to the interest which is $1050. Sum of two is $1350.
At this final step we have to divide above amount with principal amount and period of the loan and multiply it by 100 i.e. ($1350 / ($5000*3)) * 100 = 9%.
The APR on John’s loan is 9%.
You can see that although the interest rate on the loan is only 7% but in reality, the cost of your loan is 9% when other costs and fees are included. If this loan had interest which was compounded annually still the APR would remain same.
APR on Payday Loans
When looking at the fees for borrowing a payday loan, it may seem inexpensive and you may immediately fork out the fees for instant cash. But, these payday loans are deceptive until you calculate APR and realize how expensive it can be. This gives another reason to look out for other options if you are considering to take payday loan.
Calculation of APR for payday loan is similar to that of calculating normal APR. To calculate the APR for payday loan:
- First divide the borrowing fees by the loan/principal amount
- Multiply the above number by 365
- Now divide the above calculated value by the term of loan and multiply it by 100.
For example, if you take a $200 payday loan that is due on the 14th day from the day of borrowing and it has borrowing fees of $30. So, the APR will be 391% which is exorbitantly high.
APR and Credit Cards
Your APR will tell your interest rate on credit card but your APR will not show the effects of compounding interests, due to this you will always be paying more than the estimated or quoted APR by the credit facilitator.
When you carry the balance of your borrowed money on credit card, you have to pay interest on the borrowed money and there is also interest on the past accumulated interest. This is the compounding where you have to pay interest over interest and this makes cost of borrowing higher than what you may have anticipated.
Different card companies have different policies some charge only interest and some may have card fees which is charged annually. So, it is advised to do your research while getting a credit card as there are many factors affecting APR on credit cards.
Disadvantages of APR
Overall APR is an easy way to calculate how much you will pay every year over your borrowed money but, this method of calculating the cost of borrowing is not perfect. Using APR as the sole method to calculate the cost is not good because
- Your calculated APR will be accurate only if you know that you are paying your loan within the defined term. But, if you are not able to pay your loan within the defined term or if you refinance the loan then your APR will change.
- APR will vary with the lender and different lenders have different interest rates, fees and policies. Hence, it is advised to thoroughly check interest rates and fees associated with the loan as there may be hidden fees. This hidden fee may not be added up to APR and thus, give you incorrect APR.
- Also, compounding effect of interest rate is not accounted into APR. If your interest is being compounded then you should consider some other metrics to calculate cost of borrowing.