Annual percentage rate (APR) – definition and meaning
The annual percentage rate of charge or APR is a term used to describe nominal APR or effective APR (EAPR). APR is the rate that the bank or lender quotes on a loan. In other words, it is the annual interest rate that the lender expresses as a simple percentage.
Put simply; annual percentage rate is the interest rate for a whole year, as opposed to a monthly rate, on a loan, credit card, etc.
According to Cambridge Online Dictionaries, APR is the:
“Annual Percentage Rate: the rate at which someone who borrows money is charged, calculated over a period of twelve months.”
Nominal APR is the simple interest rate for a year, while EAPR is the fee plus compound interest rate. Therefore, if you want to see a loan’s true cost, you should convert the APR into the EAPR.
The annual percentage rate does not incorporate the compounding effects, but the annual interest rate does.
APR has a higher rate compared to the stated note rate or the rate that a bank advertises on a loan. The annual percentage rate takes into consideration interest and other credit costs.
APR is a tool that lenders use to compare loan options.
Lenders typically have to provide information on the cost of borrowing as a means of protecting the consumer.
In fact, in most countries, lenders by law must show the APR. For example, in the United States, the federal Truth in Lending Act made it mandatory.
Not only does this regulation protect consumers, but it also allows them to compare borrowing costs.
Annual percentage rate example
Let’s imagine, for example, that you took out a mortgage for $400,000 with a 6% interest rate. Your interest repayment expense would be $2,000 per month or $24,000 per year.
However, let’s also imagine that the purchase of your property incurred loan origination fees and mortgage insurance. Additionally, there were other closing costs. The fees and costs amounted to $10,000.
To determine your loan’s APR, you have to add $10,000 to the original loan. Subsequently, your total loan is $410,000.
You then use the 6% interest rate to calculate a new annual repayment amount of $24,600. Therefore, your monthly interest payments are one-twelfth of $24,600. The $24,600 annual total works out at $2,050 per month.
How to calculate annual percentage rate (APR):
There are three main ways of calculating APR:
- You can calculate APR by compounding the interest rate on a yearly basis. However, you do this without taking into account fees.
- Adding origination fees to the balance due, and then using that amount as the basis for calculating compound interest.
- The lender amortizes the origination fees into a short-term loan, which is due in the first payment(s). The unpaid balance is amortized as a long-term loan. Therefore, the extra payments focus on clearing origination fees and the interest that the lender charges on that amount.
Fixed vs. variable APR
Some lenders may offer either fixed APRs or variable APRs, while others offer both.
If the bank guarantees that it will not change the interest during the life of the loan, it is a fixed APR. Likewise, a fixed-rate mortgage, for example, is a loan whose interest rate never fluctuates.
A variable APR, on the other hand, has an interest rate that might fluctuate at any moment.
Video – What is APR
This video will help you understand the way lenders calculate APR and what it means.