Annual Percentage Rate: Why You Should Know About it Before Taking a Loan

While taking a loan, we all tend to focus on the advertised interest rate to determine the cost of the loan. But, do you know, the advertised or nominal interest rate does not reflect the actual cost of the loan. And, the loan with a lower interest rate also does not mean it is the cheapest in the segment.

The inaccuracies or variations in the actual cost of the loan is because it does not include the costs and other charges of borrowing. Due to this reason, at the final stage of calculations, the actual interest rate always tends to be higher than the advertised rates.

Therefore, we need to follow a standardised computational process, such as following the APR or annual percentage rate for calculating interest rate to know the actual cost of borrowing.

Annual Percentage Rate

The annual percentage rate is the most effective rate when it comes to comparing loans of different lenders. The APR factors in all the fees and costs, major or minor, while calculating the interest cost of the loan. The fees include processing fee, administrative fees, insurance costs, rebates and other miscellaneous expenses.

In simple words, APR is a combination of base rate plus all the costs involved in getting the loan. It does not consider compounding while calculating the interest cost. The formula for calculating APR is:

APR= [{(Fees + Interest)/ Principal}/ n]*365*100

n= tenure of the loan in days

For example: For a loan amount of Rs 6 lakh for 2 years tenure, with an interest rate of 8% and processing fee of 2% and insurance cost of Rs 5,000, the APR would be:

APR= [{(17,000+96,000)/6,00,000}/730]*365*100 = 9.41%

You can see that the actual cost of a loan is way higher than the advertised rate of 8%. The APR should always be equal or higher than the nominal interest rate. APR is very useful when two or more lenders have the same nominal rate on the loan offered.

However, like every other financial metric, APR also has certain limitations such as it works best only with a fixed interest rate. It is not effective for comparing the short duration loan.

Final Words

Calculating interest expense is not a straightforward process as advertised, but it involves many factors. APR helps you to know the actual borrowing cost beforehand and lets you effectively choose the lender.

Therefore, always ask for APR while taking a loan from your bank or lender, or the costs involved in procuring the loan to self-calculate it.