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Annual Percentage Rate or APR is a yearly rate of interest that includes all
of the fees and expenses paid to acquire the loan or credit card. APR can vary
anywhere from around 3% right up to 21% and beyond.
APR for Loans:
APR is a standardized expression of the interest rate that applies to a loan or
credit card, taking into account at least some of the one-time fees that are
applied by the lender. There are several ways to calculate APR, but the process
generally includes 3 main steps. Firstly, all one-time costs are added onto the
loan amount. Next, the monthly repayment for the loan is calculated based on the
loan's specified interest rate. Finally, the interest rate, that would have to
be applied to the full loan amount in order for its repayments to equal the
calculated monthly repayment, is calculated.
To see this in action, consider the following simplified example where you
borrow $1,000 and there is a loan setup fee of $50, making the total amount
borrowed $1m050. If the interest rate is 10% (compounding monthly) and the term
of the loan is 12 months, then you will need monthly repayments of $92.32 to pay
off the $1,050. However, a for the monthly payment of a 12 month, $1,000 loan to
be $92.32 would require an interest rate of 19.32%. So, the APR is 19,32%. If
the term of the loan was longer, for example the loan was for 10 years instead
of 12 months, then the loan fees would be spread across this period, and the APR
would drop significantly.
The aim of using APR is to calculate a total cost of borrowing, and to make the
interest understandable to an average consumer, so that they can compare loans
to determine the best deal and also understand the loans that they already have.
Unfortunately, despite repeated attempts by regulators to establish a single
standard for the calculation of APR, it does not always represent the total cost
of borrowing nor does it really create a standard that allows consumers to
precisely compare the costs of a loan.
The main issues in the calculation of APR arise because the definition for the
calculation of APR does not specify which one-time fees must be included and
which can be excluded. For example, should APR take into account fees and
commissions that are paid to someone other than the lender ? Should APR include
penalties, such as late fees ? As a result, it is partly up to the lender to
determine which fees are included (or not) in the calculation of APR.
In addition, APR is also highly dependent on the term of the loan. For example,
the APR for a loan with a 25 year duration cannot easily be compared to the APR
for another loan with a 15 year duration.
APR for Credit Cards:
For credit cards the APR is a much simpler calculation. Due to the fact that the
amount of money borrowed really isn’t known, you can not use the formula that is
used for most loans. It’s simply a calculation of what the effective interest
rate is for one year when you take into account that the interest is compounded
monthly.
The formula for this is apr=(interest/12 + 1)^12. So for a card with a 10%
interest rate it would be apr=(0.1%/12)^12, which is apr=1.0083^12, so apr=1.104
or approximated 11%. Really you should never have to calculate this yourself
though.
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