How To Calculate APR

It is time for you to seek external funds or a loan. There are many ways to choose a loan, many aspects to consider before you decide on the loan you want, and from whom you would like to take it. This should be a carefully considered decision as it has financial implications - a loan can help either you or your business forward or it will bind you and hold you back from progressing on your journey of success.

All those financial institutions that lend money are required by law (the US government's Truth in Lending Act) to quote the APR or the Annual Percentage Rate. This rate helps all potential borrowers to have a rate by which to compare percentage costs of various loans.

An APR comparison need not always be an apple-to-apple comparison due to various reasons like some fees and charges not being included in its calculation, like the down payment on a loan being really big offsetting the advantages of a good APR.

APR is the total cost of credit and is a combination of the total interest payments over the life of the loan and all the other fees that are paid on it. It does not affect the monthly payment of a loan.

The APR is the equivalent interest rate between loans after consideration to all costs involved in the loan. Hence, if there were no extra costs or fees to a loan, then the APR would be same as the interest rate.

All this becomes much simpler if you know how the APR is calculated and therefore how much you can rely on it.

These examples will help in understanding how to calculate APR

Example 1

Loan Amount on a fixed rate mortgage is $ 100,000

Term - 6 months

Rate - 30%

Annual Percentage Rate would be found by annualizing the interest rate i.e.  0.30* 2 (two six months making a year) = 60% per year.

Example 2

Loan Amount on a fixed rate mortgage is $ 100,000

Term - 6 months

Rate - 30%

If in the same example as the first one, the above amount cannot be paid back in the six months period and is paid back only by the end of one year (i.e. two six month periods), then the APR calculation would be like this:

Loan Amount to be paid back - $ 100,000

Interest for the first six months - $ 30,000

Interest for the second six months - $ 30,000

Total interest due at the time the loan is repaid - $ 60,000.

Notice that there is no calculation of interest on the interest amount due of the first six months. This means that the APR method of calculation ignores the effect of compounding.

APR calculations can get complex with more variables built in and when you have different loan structure options available from different lenders. The usually used method is the Newton-Raphson method for iterative APR calculation, the actual interest rate is used on the loan amount and then worked back to calculate APR. There are also APR calculators available on the net to help you arrive at a loan decision faster.


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