What is APR and How to Calculate It
The Annual Percentage Rate (APR) is a broader measure of the cost of borrowing money. It represents the yearly cost of a loan, including not just the interest rate but also certain fees associated with obtaining the loan. Understanding APR is crucial because it provides a more accurate picture of how much a loan will truly cost you over a year.
Why APR Matters
While the interest rate tells you the percentage of the loan amount charged as interest, APR includes other charges like origination fees, discount points, and administrative costs. These additional fees can significantly increase the overall cost of borrowing, especially for shorter-term loans. APR allows for a more standardized comparison between different loan offers.
How to Calculate APR
The formula for calculating APR can be complex, but a simplified version for a cash loan can be derived from its core components: the finance charge, the loan amount, and the loan term.
The basic idea is to determine the total cost of the loan (finance charge) as a proportion of the amount borrowed (loan amount), and then annualize this cost based on the loan's duration (loan term).
The formula used in this calculator is:
APR = [ (Finance Charge / Loan Amount) * (365 / Loan Term in Days) ] * 100
Let's break down the components:
- Finance Charge: This is the total dollar amount you will pay in interest and fees over the life of the loan.
- Loan Amount: This is the principal amount you are borrowing.
- Loan Term (Days): This is the duration of the loan, expressed in days.
- 365: This constant represents the number of days in a year, used to annualize the cost.
- 100: This is used to convert the resulting decimal into a percentage.
Example Calculation
Let's say you take out a loan with the following details:
- Finance Charge: $500
- Loan Amount: $10,000
- Loan Term: 365 days
Using the formula:
APR = [ ($500 / $10,000) * (365 / 365) ] * 100
APR = [ 0.05 * 1 ] * 100
APR = 0.05 * 100
APR = 5.00%
Consider another example with a shorter term:
- Finance Charge: $200
- Loan Amount: $5,000
- Loan Term: 90 days
Using the formula:
APR = [ ($200 / $5,000) * (365 / 90) ] * 100
APR = [ 0.04 * 4.0556 ] * 100
APR = 0.162224 * 100
APR = 16.22%
This demonstrates how a higher finance charge relative to the loan amount and a shorter term can lead to a significantly higher APR.