What is meant by annual percentage rate?

Annual percentage rate (APR) refers to the interest rate paid by a borrower each year on a loan, credit card or other types of credit. It is represented as the percentage of the total balance that is to be paid by the borrower.

Different borrowing instruments may come with different interest rates. However, APR can be used to compare different types of borrowing options. The loan or credit card offering with the lowest APR can be deemed as the least expensive option. Simply put, APR is the annualized representation of the interest rate borne by the borrower.

APR denotes the real cost of the loans over the period of one year that must be paid back to the lender. Borrowers must have knowledge about APR before filing for any kind of loan.

How is APR different from nominal interest rate?

Nominal interest rate is charged in every given loan, and it strictly represents the amount of interest to be paid and no other costs. A loan may come with other additional costs like processing fees, pre-closure charges, etc. which are not factored into the nominal interest rate.

However, APR factors in all these costs and provides an overall cost summary associated with taking a loan. The APR is usually higher than the nominal interest rate as it already includes the nominal interest rate and additional costs over it.

The rate quoted by banks and credit card companies is only the nominal interest rate as it does not factor in other costs. However, APR is designed to give borrowers a clearer vision about the loan or debt they are going to enter.

How does APR work?

APR is expressed as a percentage and calculated as the percentage of the principal that is paid each year, including all costs. APR does not include the compounding of interest within the year. Credit card companies may present the interest rate as a monthly charge; however, they are mandated to provide the APR to customers to maintain transparency.

For credit cards, there may be a no interest facility available to the borrower. If the borrower can repay the entire card amount within the period of one month, known as the grace period, then he/she may not be charged any interest by the credit card issuer.

However, if the balance is carried over on the card, then APR may be charged.

How is the APR calculated?

APR is simply calculated by taking the periodic interest rate and dividing it by the number of periods for which the interest is applied. In this, the nominal interest rate is not taken as a percentage but rather as the total interest amount paid throughout the course of the loan.

Here, the interest refers to the total interest amount accumulated over the course of the loan and not the interest rate. Principal is the total amount taken as loan, and n is the number of days under the term.

Usually, banks may provide the borrower with the APR option while applying for the loan. There are also APR calculators available on the internet that would ask the borrower to enter the interest rate, loan amount, ROI, and processing fees. With just a click of a button, the APR can then be calculated.

How is APR decided by the banks?

The APR may differ depending on the bank as it changes with the amount of interest rate charged by each bank. Banks might decide what APR to charge based on the profile of the borrower. This includes the borrower’s debit and credit history, details of previous transactions, income sources, etc.

Banks calculate the APR after applying the standard interest rate. The final APR is calculated on the total amount offered to the borrower.

Why is APR important?

Lenders may often keep interest rates lower while racking up other fees and charges. This is done to attract more customers and give the image of the loan being less expensive than it actually is. The annual interest rate shown by the banks is often less than the actual costs accrued to the customers.

APR comes in handy while calculating mortgage loans or loans against property. This is because such loans often include various hidden costs in the process of verification and appraisal of the loan. Higher processing fees and administration costs add to the interest rates offered on such loans.

Thus, the APR is helpful in finding out which lender is suitable for the borrower.

What are the types of APR?

Credit cards may have multiple APRs charged on them. These include the following:

• Purchase: This rate applies to online purchases, and online merchants or bill payments.
• Introductory: These might be relatively lower rates that are offered in the beginning. However, these rates have an expiry date and the final rate charged to the borrower is higher.
• Balance transfer: This is the rate paid on the debt that is moved over to the credit card. This rate may start with a lower level and may be a balance transfer fee.
• Cash advance: Rates may be relatively high under this category as this is the rate charged for getting cash from an ATM.
• Penalty: This rate is charged in case of late payments. It may rise; however, this increase can be curbed by making consistent on-time payments.

How APR is Different from Annual Interest Rate & Effective Annual Interest Rate?

Both the annual interest rate and effective annual interest rate are slightly different from the annual percentage rate. Annual interest rate is the basic interest rate charged while lending out a loan. It is paid without considering the compounding of the interest or any fees.

While effective annual interest rate is a percentage value which includes the compounding value of interest over the life of the loan. It provides a better idea of the interest that would be paid monthly.