Annual Percentage Rate (APR) is essentially a cost comparing mechanism set out to make loan more transparent to borrowers. It is usually used to compare the costs of a loan. While no prcecedure or mechanism is perfect, APR does give borrowers an more standard way to compare percentage costs on various loans.
Why use APR?
We all know that APR is helpful in comparing perecentage cost of loans, but the objective of coming up with APR is actually for the benefit of borrowers. Although loan may sound like a straight-forward and simple procedure, it is actually very complicated and complex. Often then not, most potential borrowers may find it difficult to understand when lenders start to throw in many types of numbers. That is why, APR is being developed to help reduce such confusion.
What exactly is APR?
It is actually the annual percentage interest rate. In an instance where a borrower take up a loan of $1000, if the Annual Percentage Rate (APR) is at 10 percent, it means the borrower has to pay $100 per year as interest. This interest is the cost for borrowing that $1000 as a form of loan. It is therefore prudent for people seeking a loan with the lowest APR.
How to calculate APR?
It is a simple calculation for ‘Nominal APR’ which is the annual interest percentage. If the loan amount is $1000 and the APR is at 10%, the monthly cost for this loan is – 0.1 X $1000 / 12 months
Why APR is not a perfect way to calculate costs of a loan?
So that is why, APR is not a perfect menthod to calculate the real costs of a loan. If there is a need to understand how much does a particular loan would cost you, you will have to use another form of calculation known as the Effective Annual Percentage Rate (EAR).
Effective APR of 10% can be expressed in the following ways:
a) 0.7974% effective monthly interest rate, because 1.007974^12=1.1
b) 9.569% annual interest rate compounded monthly, because 12X0.7974=9.56
c) 9.091% annual rate in advance, because 1/1.1 = 0.091 subtracted by 1
It would be ideal if loans can be compared with APR with everything else being equal. But the truth is that ‘everything else’ are not equal. in EAR, a loan should be factored and calculated in consideration with loan participation fee, service charges, origination fee, late fees and compounding interest.
The intention of introducing APR is to standardize and to protect the consumer from slick lenders. It is required for lenders to disclose the loan APR clearly before the application of the loan has been finalized. It may not be perfect, but at least borrowers are made known to the main interest rate and not the adverstised ‘note rate’ or headline rate’ which only show the monthly rate that seems ‘cheap’.