Understanding What is Annual Percentage Rate (APR)
Prior taking a personal loan, payday loan or any kind of loan, it is really important to make sure you understand what APR stands for. In this article we will cover simple explanation, what it is and how to calculate it.
APR or Annual Percentage rate is the actual annual interest rate charged on loans or annual interest rate that investment earns. In theory, this is the actual numeric percentage representation of the interest that funds earn in a year, on loans is the interest of the principal owed and on investment the interest the investment earns. However, in calculating the APR the fees or other costs associated with the transaction are included in the computation but are not accounted as compounding.
A loan or credit may charge a monthly interest rate of 3%; its APR for one year is 3% x 12 months = 36%.
The Important Role of APR in Credit and Loan Agreements
At the most basic credits or loan agreements can have different terms of transaction fees, interest-rate structure, surcharges or late penalties plus others. APR as a standardized computation can balance these differences, enough to provide the threshold which borrowers can compare to the interest rates charged by different lenders.
The credit and lending laws are explicit in laying down the terms that will protect the rights of borrowers to form informed decisions when it comes to utilizing loans or credit products. Lenders and credit companies can advertise their products using the low monthly interest rates they are charging for each loan or credit product to pitch their sales spiel. They can, by law. However, they are also required to clearly state on each loan agreement the APR covering each transaction. Everything must be fully understood by the borrower before an agreement is finalized, so they must discuss these thoroughly.
Breaking Down APR into Basics
There are 2 types of APRs. A fixed APR and variable APR. With a fixed APR the borrower has the guarantee that the interest rate of the loan the borrower has taken will not change within the duration of the loan term and the lifespan of the loan or credit facility. Whereas with a variable APR a loan can change interest rates at any time within the duration of its loan term.
Comparing APR and Nominal Interest Rate
A nominal interest rate is only the interest charged on a loan, no more no less. It does not take into account other costs and fees. APR is the opposite, other costs and fees associated with the transaction are also accounted in addition to interest rate. Resulting to a higher interest rate than nominal interest.
A property loan of PHP 50,000 is charged a 5% interest rate, for one year your interest expense amounts to PHP 2500, or a monthly interest payment of PHP 208.33.
But property purchase requires appraisal fee, registration expenses, documentary stamp tax (P1.00 for every P200 of the loan amount), mortgage redemption insurance and handling and notarial fees, which totals to PHP 5,000.
Now, your property loan’s APR, is the original amount you loaned plus these fees, totaling all in all to PHP 55,000. Calculating a new annual payment for the new amount, with the 5 % interest rate, it now totals to annual interest expense of PHP 2750. Now, divide the annual payment of PHP 2750 by the original principal amount of PHP 50,000, your APR will then be 5.5%, which is slightly higher than the first APR without the added costs.
The worse case scenario is when the borrower doesn’t know how to calculate APRs. Now this is important. The universal law on lending or credit services requires all credit and lending services to list APRs along with the offered nominal interest rate in the loan agreements. Don’t be confused when there are two lenders offering the same nominal rate and monthly payments on loans, but the APRs are different. If such a case arises, go with the lender with the lower APR. This lender is requiring very minimal upfront fees and is offering the better loan terms.
Also Read: Types of Loans Available in Philippines