How Are Interest Rates and APR Percentages Calculated?
Before you head to the bank to take out a loan for a new car, small business or other investments, take the time to fully understand how your interest rate is calculated. This will help you to better understand your loan terms and conditions with your bank, and put you in a better position to negotiate your rates. The bank always has wiggle room with their rates – don’t be shy to negotiate. Once you have a better understanding of how interest rates are calculated, you’ll be ready to choose the best personal loan for your needs.
What is Interest?
Banks and lenders are in the business of making money. If they loaned you $10,000 and you gave them back $10,000, they’d make no money on the transaction and would have no additional money to lend to other consumers. Therefore, they charge interest; described in the simplest of terms as a percentage of money that is paid regularly at a particular rate for the use of money lent to the consumer.
Let’s take a look at how banks calculate interest on a 1-year loan:
If you borrow $10,000 from a bank for one year and are required to pay $600 in interest for that one year, your interest rate is 6%.
Simple enough, right? Keep in mind that the above formula is for a simple interest loan and doesn’t take into account compound interest.
What is APR?
APR or annual percentage rate is the amount of interest that you will pay on a loan over the course of a year. Many people mistakenly believe that the bank’s interest rate is also the APR. These are two different figures. The APR is how much the loan is actually going to cost you not only in interest charges but additional fees as well.
Interest vs APR: What’s the Difference?
Interest rates and APR are not interchangeable – they are 2 very different parts to a loan. If the bank advertises that it will lend you money at 6% interest, it means you’ll pay 6% of the amount you borrowed back to the bank.
APR, on the other hand, is the amount you’ll pay back to the bank in interest and additional fees. Although this may vary from bank to bank, typical fees may include the following:
- Fees for credit reports
- Licensing and registration of vehicles
- Application fees
- Loan processing fees
- Additional service fees
If you take out a loan to buy a car that costs $10,000 and the bank is charging an interest rate of 6% it means that you will pay 6% of $10,000 in interest. The interest rate is added to the original $10,000, which is known as the principal amount. However, most loans come with fees. These fees may be charges for credit reports, application fees, and loan processing fees, among other charges. All of these fees are added to the interest you’re paying on the loan. The total of these fees plus interest is what makes up your APR. What isn’t included in your APR are any and all late fees, penalty fees and statement fees.
How is Interest Calculated on a Personal Loan?
When you take out a personal loan, the amount of interest that you will pay over the course of the loan is determined by the following factors.
- Principal – the amount you originally borrowed
- Interest rate – how much interest you’ll pay on the principal amount
- Term – how long it will take you to pay back the loan
Keeping these factors in mind, let’s figure out how much you would typically pay in interest on a 4-year car loan for $15,000 with a 6% interest rate.
First, you multiply your principal of $15,000 by your interest rate to get an annual amount of interest, which is $900 ($15,000 X .06). By multiplying the $900 times 4 years, you have the total amount of interest you would typically pay over 4 years, which is $3,600. Take into account that if you are paying the loan off with monthly payments, your total interest will be much lower because each payment is lowering the principal remaining on the loan. For this example, your monthly payments would be approximately $352 a month for 4 years, bringing the total amount you paid for the loan to approximately $16,910. That’s only $1,910 in interest compared to $3,600 if you weren’t paying on your principal each month.
Interest is actually determined by using the unpaid daily balance. In other words, the interest is calculated daily but charged each month. Your interest rate of 6% is divided by 365 to determine what your daily interest rate may be. Keep in mind, however, that this will vary by the number of days in the month. If you chose to only pay the interest on your loan and not the principal, after 4 years you have already paid $3,600 on interest and still would owe the original $15,000.
How is APR Calculated?
APR is a helpful measure for consumers comparing loan or financing options. Some financial institutions may advertise low interest rates but will have high fees that are less obvious. APR allows you to compare what a loan is costing by including the annual interest and additional service fees. The length of the loan you are receiving will also affect APR, so it is important to understand how much the total financing is costing you. For instance, if you borrow $10,000 on 3-year loan, the APR is calculated based on the interest and fees being spread out over 3 years. If you pay the loan off early, the APR is likely going to be higher, however, you will pay less in total interest.
Let’s say the bank is charging you 7% interest on a 3-year loan and charging you $500 in additional fees. Your interest rate is 7% but your APR is going to be almost 10.6% once the interest and fees are included. Learning how to calculate APR can be a very valuable tool for consumers.
It is important to understand what your loan is going to cost you over its total lifespan and how long it will take you to completely pay it off. For complete transparency, be certain that you fully understand the full terms, conditions and fees of any loan before you sign. Don't be afraid to ask questions and shop around. For answers to some of your questions about specific providers, check out our reviews of the best loan companies.