Annual Percentage Rate - How does it Affect your Loan Amount?

By
  | Published: 17 October 2021

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For starting a venture or fulfilling emergency financial needs, you may require personal loans anytime. However, choosing the right lender is crucial to avoid paying excessive interest. For most people, a lender offering a lower interest rate seems to be a reliable source of loans. But implementing this search process can cost you a higher repayment amount and impact your finances negatively in the long run. The lender disclosed interest rate doesn’t show the complete picture and other costs involved in your loan. Eventually, the total cost of your loan comes to be much higher than the advertised interest rates. 

For this reason, you need to consider the annual percentage rate, as it is standardised and cumulates all the charges and costs while calculating the final interest rate that you have to pay annually. Thus, it gives you the precise cost of your loan amount and the annual interest rate.

What does Annual Percentage Rate mean? 

By definition, the annual percentage rate is the total interest you pay against your loan amount per year. In the case of investments, APR is the annual interest rate earned without considering the compound interest within the specific year. While calculating the cost of your loan, the APR considers various charges such as processing fees, insurance charges, administrative charges that your lender may levy. In comparison to the annual interest rate (AIR), the annual percentage rate (APR) gives the accurate yearly cost of your loan. 

For example, you acquire a loan of AED 100,000 with an APR of 10%. Your total annual interest rate, in this case, would be AED 10,000 in one year against your loan. 

The lenders and the financial institutions need to disclose their APR to the customers while offering them the loan. In the case of credit cards, the issuers may publish monthly interest rates, but they also need to mention the APRs. 

How is the Annual Percentage Rate Calculated?

As mentioned above, the annual percentage rate takes various charges and fees into account while calculating the total yearly interest. The following formula is applied to calculate your loan APR. 

Annual Percentage Rate (APR) = ((Charges+Interest)/Principal/N)*365*100

Where:

  • Interest means the total interest to be paid throughout the loan tenure
  • The principal means the loan amount
  • N is the number of days in the loan tenure

In a broader sense, your annual percentage rate depends on the loan interest rate. However, you need to consider your APR and the interest rate to get an accurate cost calculation of your loan. 

How Does an Annual Percentage Rate Work?

While borrowing a loan or any type of credit, your issuer applies APR to denote the amount you need to pay every year in the form of interest. For credit cards, the APR and the interest rates are similar. But for loans such as a mortgage where you need to pay closing costs, the APR includes those charges as well. Additionally, credit card annual membership fees, late payment fees, etc. don’t impact your annual percentage rate. 

When you purchase something using your credit card, the card issuer applies an annual percentage rate for calculating the interest to be charged on your outstanding balance. Several financial institutions use your daily balance for calculation, and that’s the daily interest amount you owe. To find out the daily interest amount, you can use the above formula. 

Let’s consider an example of a credit card to understand the working of APR better. 

Let’s say you have a credit card with an APR of 15% and a daily balance of AED 5,000 over a particular month. The bank considers 365 days in the year, so the interest amount you incur today is - 

(15%/365)*AED 5,000 = AED 2.05 

So your interest amount for that particular day is AED 2.05

Since most credit cards have a grace period, you can pay the balances in full during the period and avoid interest charges. 

In the case of unsecured loans and mortgages, you don’t have such grace periods, so you need to pay the APR. 

The Downside of Annual Percentage Rates 

Annual Percentage Rates can be an effective way to calculate the interest. However, they aren’t always accurate. The calculation works better for the long tenure loans, but when it comes to shorter repayment tenures, the fees and costs are too thin. 

The APR does not give an accurate value when the charges and interest rates vary over time. For instance, APR doesn’t work accurately in the case of adjustable-rate mortgages since the interest rate varies over the period. Even though the APR considers the interest rate caps, the calculation assumes a constant interest rate, and it gravely understates the loan cost if the mortgage interest rate increases. 

Additionally, the APRs for mortgage loans may not take into account charges such as application fees, life insurance, appraisals and notary charges, making it difficult to compare similar products from different banks. 

To get a precise comparison, the borrower needs to take into consideration various inclusive and exclusive fees for different loan issuers and calculate the APR manually using the declared interest rate and other costs.  

What is considered a decent annual percentage rate? 

Several factors influence the annual percentage rate. A decent APR depends on the lender’s interest rates, the credit score of the borrower, and the UAE Central Bank’s prime rates. With low prime rates and issuer’s interest rates, you get lesser APR and eventually a lower loan cost. 

Despite a low APR looking attractive, you should verify whether they are introductory rates or fixed rates until the tenure. Usually, the low APRs are available to individuals with very high credit scores.

Types of Annual Percentage Rates 

Credit cards or other credit products may have more than one APR depending on their use. Following are the various types of annual percentage rates - 

  • Purchase Rates - The rates apply on various purchases such as online shopping, retail spending, bill payments, etc. 
  • Introductory Rates - These rates are low and generally given to new customers. The rates are temporary, and after the expiration, the APR increases over time. 
  • Balance Transfers Rates - The banks apply balance transfer rates when you transfer outstanding balances from one credit card to another. Initially, you get low promotional rates and they increase gradually. Additionally, you might also have to pay processing fees for balance transfers. 
  • Penalties - Penalties generally arise due to late payments and your rates shoot up due to this. However, you can bring your charges down with on-time future payments.
  • Cash Advances Rates - These rates apply when you withdraw cash from an ATM using your credit card. The cash advance rates are high and you may also need to pay additional charges for cash withdrawals. 

The Bottom Line

Annual percentage rates (APR) are crucial in determining the precise interest amount you need to pay in a year. The APR depends on the prime rates and the issuer’s interest rate and they help significantly in comparing similar loans or other credit products from different banks. The lenders and banks usually advertise the nominal rates, so the borrower needs to verify the annual percentage rate to know his actual loan cost.