Tuesday, November 29

Important Factors To Know About Annual Percentage Rate (APR)

APR or the annual percentage rate is a financial term that signifies the interest rate one has to bear and/or receive on a loan or an investment, respectively. This concept is applicable to every financial product starting from a loan to a deposit. Moreover, APR is primarily expressed in percentage terms.

Nevertheless, for novice borrowers, this can be a confusing concept. To clear this doubt, one can read along to better understand this concept.

Calculation of APR

Individuals can take help from a simple annual percentage rate formula to calculate the percentage and evaluate their loan’s total cost before availing of a loan from a financial institute. The formula is given below-

APR = [{(Loan Interest + additional charges)/Principal}/n] * 100 * 365

Where:

  • Loan Interest is the total interest paid through the life of the loan
  • Principal refers to the total loan amount
  • n refers to the loan tenor involved expressed in days

Besides this manual method of calculating APR, individuals can use simple and easy to use financial tools like APR Calculator to get proper computation.

Working Process of annual percentage rate

Whenever an individual or a borrower borrows money in the form of a loan, such as to buy a house, car, or other essential needs, there is an extra cost for repaying this money, which is called interest. The annual percentage rate is the percentage that determines the total amount that one has to bear as interest payment of any credit.

Let’s understand with an example – an individual is willing to apply for a home loan of Rs.10 lakh with a repayment duration of 5 years. The interest rate charged against the loan is 10%, the processing fee is 2.5%, and the insurance costs Rs.3,600. The overall calculation of APR is-

The overall processing fee is Rs.25,000, the entire fee, including insurance cost, is Rs.28, 600 and the interest cost is Rs.5,00,000. Now, as per the above mathematical formula of APR-

APR = [{(28, 600 + 5, 00, 000) / 10, 00, 000} / 1825] * 365* 100

= 10.57%

The overall cost of a loan is estimated at 10.57% for 5 years and is greater than the nominal interest rate.

Factors that influence annual percentage rate 

Before availing of a loan, an individual should know that many factors influence a loan’s APR. The most important factors that influence APR include the following:

  • Credit score and history

The credit score and repayment history of any individual is the most influential factor of APR. If their credit score is high, typically 700+, they can get a loan with a lower interest rate. Apart from the credit score, credit history, credit utilisation ratio, history of payment, and credit mix, i.e., the different types of debt an individual have, making payments on time etc., also plays a part here.

  • Debt-to-income ratio

This is an individual’s debt-to-income ratio is another important factor that influences the APR of a loan. It is defined in the form of a percentage. Lenders prefer those with a lower debt-to-income ratio as they have better disposable income to meet other financial obligations.

  • Fixed or variable interest rate

Fixed and variable interest rates are directly tied to the APR against a loan. A variable home loan interest rate is a fluctuating interest rate during the loan term, depending on market factors. A fixed interest rate will remain the same throughout the loan period. Generally, fixed rates are always higher than variable rates. 

  • Loan period

If the loan period is long, then the interest rate will be high, and vice versa. The reason being with a longer repayment tenor the lending risk is higher. However, one needs to be careful while choosing a loan tenor as it will determine his/her total debt.

Besides a competitive interest rate, leading financiers also extend pre-approved offers that streamline the loan application process and save time. These offers are applicable on financial products like home loans, loan against property etc. Borrowers can check their pre-approved offers by submitting their essential contact details like name and contact number.

Understanding the concept of this annual percentage rate is imperative for every prospective borrower. It will help them to have a better idea of their debt and plan their finances accordingly to meet their liabilities without any hiccups.