When you’re shopping for a loan, it’s important to understand the true cost of borrowing. One key factor in determining this cost is the annual percentage rate (APR). In this article, we’ll explain what APR is, how it’s calculated, and how you can use this information to compare different loan offers.

What is APR?

The annual percentage rate (APR) is the effective interest rate you’ll pay on a loan over its lifetime. It includes not only the interest rate but also any other fees and charges associated with the loan. By considering all these costs, APR provides a more accurate picture of borrowing costs than the nominal interest rate alone.

How to Calculate APR

Calculating APR can be a bit complex, as it involves several steps:

1. Identify all fees and charges: To begin, identify all the costs associated with the loan. These may include origination fees, application fees, closing costs, or any other charges that may be incurred during the life of the loan.

2. Convert all fees to an annual amount: Next, convert these one-time costs into annual amounts by dividing them by the loan term (in years). For instance, if you have $3,000 in closing costs for a 5-year loan, those costs would equate to $600 per year ($3,000 / 5).

3. Add annual fees to annual interest: The next step is to add your newly converted annual fees to your actual yearly interest payments. To calculate your yearly interest payments, multiply the loan amount by the nominal interest rate.

4. Divide by principal: Finally, divide this total figure by the initial principal amount of the loan (i.e., how much you borrowed). The result is your effective annual rate (EAR).

5. Convert EAR to APR: The last step is converting your effective annual rate (EAR) into an APR. To do this, use the following formula:

APR = (1 + EAR) ^ (1 / n) – 1

Where ‘n’ is the number of payment periods per year. For most loans, this number will be 12, as there are typically 12 monthly payments in a year.

Comparing Loan Offers

Now that you understand how to calculate APR, you can use this information to compare different loan offers. Look for loans with the lowest possible APRs, as these will generally be the least expensive options. Remember, however, that other factors – such as the repayment term and the loan’s flexibility – may also influence your choice.

Bottom Line

The annual percentage rate (APR) is an essential tool for comparing the true cost of different loans. Be sure to calculate and compare APRs when shopping for loans, so you can make informed decisions about which borrowing options are best for your financial situation. Keep an eye on fees and charges associated with each loan offer, and remember that a lower nominal interest rate does not necessarily mean a lower overall borrowing cost.