LOAN FAQ: Annual Percentage Rate

All About Annual Percentage Rate (APR)

Annual Percentage Rate: General Overview

APR, or Annual Percentage Rate, is a rate charged per year on an amount of money that is borrowed as a loan or invested which factors in associated fees in addition to the interest rate. It is designed to give a more accurate estimate of the total cost of a loan or investment than considering the interest rate alone would.

Factors to Consider

When taking out a loan, there are three main factors that affect the total cost of the loan.

  • ◉ Principal
    The principal is the initial amount given as a loan.

  • ◉ Interest Rate
    The interest rate, also called the nominal interest rate to emphasize the distinction from annual percentage rate, is the rate at which the balance of the loan will increase over time.

  • ◉ Associated Fees
    There are usually a set of fees associated with taking out the loan, such as closing costs, origination fees, or insurance fees.

This would only not be the case if a loan has no additional fees at any point in its lifetime. Because the nominal interest rate of a loan can therefore be misleading, the Truth in Lending Act requires by law that all consumer lenders, such as credit card companies, disclose the APR of their loans, even though they are also allowed to advertise the nominal interest rate.

Calculating the Annual Percentage Rate

Let’s say that you were to take out a loan of $10,000 at 10% interest, with a term of 10 years that will be paid back at the end of the term.

That would make your annual interest expenses $1,000 per year.

Let’s also assume your bank has included fees associated with the loan totalling $500. To get the APR of this loan, you need to add the cost of the fees to the total amount in interest paid. Spread across a 10 year period, the additional $500 charge is divided by 10, which is $50 per year.

$50 is 0.5% of the $10,000 loan, adding 0.5% to the annual percentage rate.

Therefore, the annual percentage rate is 10% + 0.5% = 10.5%.

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