Annual Percentage Rate - Definition, Meaning & Calculation Formula

A loan from any institution is a significant financial move that can affect you and your loved ones. While many banking institutions advertise a provisional interest rate on the borrowed amount, an Annual Percentage Rate helps discover the true expenditure and various annual charges. This amount enables you to budget your finances better and understand how much a loan will cost the borrower over a longer tenure.

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What is the Meaning of Annual Percentage Rate?

Annual Percentage Rate, or APR, is the yearly interest rate borrowers pay the investor. In layman’s terms, the APR represents the actual income generated from a financial investment by the lenders. Besides compounding interest, APR includes every additional cost associated with the lending transaction and helps borrowers compare the loan terms offered by every bank or investment firm.

Given the borrower’s overall creditworthiness, the lender might charge different APRs from different individuals for the same loan amount. Some of the fees included in the Annual Percentage Rate are administrative fees, insurance premiums and processing charges. This rate also helps borrowers understand the actual loan amount and interest to be paid yearly instead of what was advertised by the banks.

An example of APR is that if you go to a restaurant and eat food worth INR 700, you must pay a lowered interest rate of INR 20 and a service charge of the eatery for INR 8. So, while the interest rate is only (20/700 * 100) 2.85%, the APR comes to be (28/700 * 100) 4%.

The higher the APR on a loan, the more a borrower has to pay the lender monthly, and vice versa.

Why Does Annual Percentage Rate Affect Your Financial Health?

The annual Percentage Rate reflects the amount owed to the lender and helps borrowers with better financial planning. Here are some of the reasons why this metric might affect your financial health in the long term:

Informed Financial Planning

After analysing the customer’s assets and liabilities, different banks offer different APRs, which means that the borrower holds the power to take a loan from the bank with lower interest rates without worrying about hidden costs.

Improving Creditworthiness

Borrowers who choose lower APR banks can achieve better financial stability and improve their creditworthiness by paying their loans on time. This factor can also help them acquire new credit cards or apply for more loans.

Transparency

APR ensures that every financial institution works transparently and does not ask its clients for more money than they agreed to in the agreement, preventing financial burdens or fraudulent transactions. Borrowers can learn their loan’s true value and impact after analysing the difference between interest rates and the Annual Percentage Rate.

Understanding How Annual Percentage Rate (APR) Works and How to Calculate It

Calculate an APR by multiplying the actual interest rate by the loan tenure. However, this rate can vary occasionally in cases of non-payment of bills and increasing credit card debts.APR does not consider compounding interest, so it only finds the simple interest rate for the year.

The exact formular for APR is:

((Fees+ Interest/ Principal/ n) * 365 ) *100

Where:

Interest is the total interest rate
The principal is the total loan amount
N is the number of days in the loan term

Credit card companies often charge interest on outstanding payments and will even start charging interest on each transaction in case of exceptional payments over the limit. To calculate the daily periodic rate for each transaction, you can use the following Annual Percentage Rate formula:

APR Rate on the Card/ Days = Daily Periodic Rate

You can also find out your monthly interest rate by this formula:

Daily Balance * Periodic Rate * Days of the Billing Cycle = Monthly Interest Charge

Understanding The Components of APR

Here are the various components that help calculate the correct APR on loan:

Interest Rate: The interest rate is a set percentage of the principal amount (Simple or Compound), which can be changed only after mutual agreement between the lender and borrower.
Fees: The various fees associated with taking a credit loan from any banking institution, including the processing fee and annual fees, must be added to the overall interest, which can significantly increase the overall borrowing cost.
Time Period: The loan’s tenure plays a very important role in calculating the APR value, as the longer the repayment period, the less the borrower has to pay to the lender monthly.
Principal: The principal is the loan amount to be paid by the borrower without any taxes, charges, or interest.

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What are The Various Types of APRs?

Here are the various types of APRs which help in analysing the loan amount payment to be paid

Purchase APR: Interest rates charged on all card purchases, online or offline
Introductory APR: Special Interest Rate, as low as 0%, that is given on special occasions
Cash Advance APR: Interest Rate used for convenience checks without any grace period.
Penalty APR: Interest Rate applied on later payments for credit cards can go as high as 29.99%

What is The Difference Between Interest Rate and APR?

Interest Rate is the official amount to be paid on any loan. In contrast, an APR on a loan should include all the payments related to the borrowed money, bank-related taxes, and other insurance payments.

Here is the official difference between the two:

Interest Rate	Annual Percentage Rate
This includes less amounts of money.	This includes more amount of money.
No other fees are included in the interest rate.	Several other fees are included in the Annual Percentage Rate.
It is based only on pre-set conditions and individual creditworthiness.	It is controlled by the lender and affected by factors like discount and broker fees
Lower Interest rates signify lower monthly payments.	A lower APR means lower overall loan costs and yearly interest payments.