What is Annual percentage rate (APR) and how is it calculated?

Calculating the Annual Percentage Rate or APR helps you to know the actual cost of borrowing money to buy a home or any other piece of real estate. You will be surprised to know that the yearly cost of taking a loan may be completely different from the rate that is advertised by banks and other housing finance corporations.

The annual percentage rate is calculated by adding all the associated costs that you need to bear when taking a loan.  In addition to the interest rate that you pay, it further includes processing fees and other charges. By calculating the annual percentage rate, you get a clearer picture of the cost of availing a loan. Therefore, APR is also referred to as the total cost of borrowing money over a one-year period.

What is the difference between interest rate and annual percentage rate?

When taking out a loan, the amount you will pay back is less dependent on the interest rate and more on the annual percentage rate (APR). This means that even if different banks offer the same interest rate for a home loan, they may have different ways of calculating processing fees, loan insurance, closing costs, and other expenses.

As a result, your loan expenses will be higher if the APR is higher, even if the interest rate is the same across different banks and housing finance corporations. To negotiate a better loan offer, it is important to understand the difference between interest rate and APR. The interest rate is the amount of money you will pay back in one year based on your loan terms, while the APR is the total amount you will pay back over the course of the loan (e.g., 30 years) based on your loan terms.

Points to remember:

• Gives you a complete measure of how much you will pay in total over your entire tenure.
• Includes the cost of borrowing the principal amount as well as other fees and charges taken by the bank or the housing finance company giving you the loan.
• Influenced by the fees and charges levied by individual agencies.
• It is higher than the interest rate.

How is Annual Percentage Rate calculated?

To calculate the annual percentage rate (APR), it’s important to understand how the interest rate is calculated on the principal amount.

For example, if you take out a loan of ₹50,00,000 for a tenure of 20 years at an interest rate of 8%, the annual interest you will pay will be ₹4,00,000. Over the 20-year tenure, you will pay an interest of ₹80,00,000, based on the 8% fixed annual interest rate.

To represent the principal amount of ₹50,00,000, we can use the variable P. To represent the total amount of interest that will be paid in 20 years, we can use the variable I (₹80,00,000).

The number of days in the tenure is used to calculate the APR. In this case, 20 years is equal to 7300 days (365×20). We can call this number N.

Since the annual percentage rate (APR) is calculated by adding all costs together, let us say that the additional costs in this scenario are as follows:

• Processing fee: 1.5% of the principal amount, or ₹75,000
• Insurance fee: ₹11,000
• Miscellaneous charges: ₹8,000

The total additional cost is ₹94,000. Let us call this variable A.

To calculate the APR, we can use the following formula, using the variables defined above:

APR = [{(A+I)/P}/N]x365x100

Where:

• P = ₹50,00,000
• I = ₹80,00,000
• N = 7300
• A = ₹94,000

Therefore, for a principal amount of ₹50,00,000 with an annual interest rate of 8%, a tenure of 20 years, and additional costs of ₹94,000:

APR = [{(94,000+80,00,000)/50,00,000}/7300] x 365 x 100 = 8.094%

As you can see, the actual interest rate that you will be paying over your entire tenure may be slightly more than 8%, which, over 20 years, can make a big difference. How? With an annual percentage rate of 8.094%, the amount of interest you will be paying comes out to be ₹80,94,000.

Why is it important to know how APR works?

It is important to know how APR works because it provides a more accurate representation of the true cost of a loan. The interest rate is a significant factor in determining the cost of a loan, but it is not the only factor. APR considers other costs associated with the loan, such as processing fees, closing costs, and insurance, and expresses them as a yearly rate. This provides a more comprehensive understanding of the total cost of the loan, which can help borrowers make more informed decisions when comparing loan offers. Additionally, APR can help borrowers understand the long-term cost of a loan and make more informed decisions about how much they can afford to borrow and how long they should take to repay the loan.