What Is an Annual Percentage Rate (APR) In Simple Language?
The term “annual percentage rate” is composed of three different words, or we can say “elements.” Let us understand each of these terms individually through the table below:
|Annual||It represents something done “once a year.”|
|Percentage||Percent (%) is an amalgamation of: “Per” & “Cent.” So, a percentage represents any figure calculated as a part of a hundred (as there are 100 cents in a dollar)|
|Rate||You go to a hotel, and pay room rent at $25 per night. Hence, a rate is a charge or the fee to stay.|
When we put all these elements together and spell “annual percentage rate,” then it represents a kind of charge or fee, which is:
- Once in the year, but can be split between the several months through simple division
- It carries a specific “monetary value,” which is known as a percentage rate
What Are the Different Areas or Situations to apply APR?
An APR is a common term in the field of banking and finance. It helps to calculate various charges and levies impacting your overall finance decisions and product choices.
In a bid to cover everything, we have divided the usage of APR across three different verticals. These are:
1. Financing Facilities – Loans, Advances, and Credits
When you obtain a financing facility from a banking institution or any private lender, you need to pay interest to them for using their money. This “interest payable” is calculated using the APR (annual percentage rate), which in this situation known as the “Loan rate.”
You usually get a favourable or lower APR if:
- You have a good credit rating/ score (usually 700 or above)
- You have an impeccable credit history with the instances of loan defaults and non-payments
- You have not made multiple negative credit inquiries
The annual interest you will pay to your lender can be calculated by multiplying the Principal Amount by the APR.
While availing loan, there will be several instances when you will feel the need to calculate an APR. You can do it using the following formula:
APR = Interest/Principal amount * 1/n * 100
- “Interest” represents the accumulated or total interest, which you will be paying throughout the loan term
- “Principal Amount” represents the amount of loan which you have obtained from your lender or financial institution
- “n” represents the number of years of the loan term
* Towards the end, we always multiply with “100” to obtain a per – cent rate.
2. Investment Avenues – Bank Fixed Deposits, Corporate Deposits, and Debentures
Saving money is an exceptional habit as it helps you during the rainy days and enables you to accumulate a retirement corpus. Most lenders accept deposits from the public in various forms and reward them by paying a lucrative APR, known as the “deposit rate.”
The APR offered by lenders varies and depends upon:
- The credit rating enjoyed by the deposit-taking agency The higher the credit rating, the lower the APR and vice versa.
- It is the form or type of deposit-taking instrument. The higher the associated credit risk, the higher the APR and vice versa.
- It is the need or urge for funds by the deposit-taking agency. The financial organizations in dire need of finance often offer lucrative APRs (Annual Percentage Rate) to attract investors.
Your return from an investment scheme depends on your APR and maintains a direct relationship with it. If you have a high APR, you will earn a higher return than the instruments with low APR.
3. Charges, Levies, and Penalties
With most financing options and investment schemes, you are usually required to pay certain charges and penalties linked to the amount of investment made or borrowing obtained.
In such cases also, your lender might issue you an APR, based on which you are required to calculate your annual charges.
What Is the Practical Working of APR in Different Situations?
Let us delve deeper and try to understand the practical working of APR through some real examples.
|I.||You Have Obtained A Financing Facility||• You are a working professional and are desirous of owning your own house in the Greater Toronto Area.|
• You have shortlisted a condo having an asking price of $500,000
• You went to a bank and enquired about a mortgage rate (APR)
• The mortgage APRs varied as per the tenure of the mortgage loan
• You are getting a 20-year mortgage loan at an APR of 4.50% and your monthly mortgage payment will be $3,163
• However, you decided to do some more research and interviewed some more lenders
• You got an APR of 3.85% as the next best alternative and in this case, your monthly mortgage payment will be $2,990
• It can be observed that the lower the APR rate, the more beneficial it is for you
• This is because with a lower rate your monthly mortgage payment will be less
|II.||You Have Made an Investment||• You are a saver and have accumulated $50,000|
• You want to invest the money in lucrative investment schemes
• You have an investment horizon of 10 years
• You went to a few investment advisors and obtained the following investment options, which have different APRs:
Name of the instrument: Debentures of Orange Inc. – APR: 7.15%
Name of the instrument: Corporate Deposit scheme of ABC Consulting Inc. – APR: 5.35%
Name of the instrument: 10 Year Canadian Government Bond – APR: 2.9%
• You observed that your annual returns were the highest when you invested in the instrument having the highest APR
• While your returns were the lowest when you invested in the lowest APR
|III.||Lender asks you to Pay Conditional Charges.||• You want a mortgage loan, and you went to a lender offering the best mortgage rate|
• You are informed by your lender that typically you will be required to pay anywhere between 3% to 6% of the loan amount in closing costs
• Besides this if you want to pre-pay and your prepayment exceeds the prepayment privileges, then you will also be required to pay a prepayment penalty to the tune of 2% of the outstanding loan balance
• All the percentages mentioned above are APRs, which are used for different purposes in different contexts
• You can use the quoted APR to calculate your additional charges, levies, and penalties