What is an Annual Percentage Rate?

When you apply for a loan, whether a car loan, mortgage or any loan with a regulated financial institution, they are bound to show you the Annual Percentage Rate (APR) of the loan agreement being offered. What you will notice is that the APR will most likely not match the interest of the loan. Why is that?

APR Definition

The Annual Percentage Rate basically is your borrowing cost (or yield) calculated to an annual basis. If a friend would lend you money for 6 months with a 10% interest charge, your APR would not be 10% but rather 20% (10% interest, times 12 months divided by 6 months).

The easiest way to understand the concept of APR it is better to think about it from the vantage point of an investor, rather than a borrower. Let's imagine that the tables are turned and you are the one lending your friend. The terms are the same and he pays you back in 6 months with 10% interest.

If you do nothing with the principal during the remainder of the year, you will indeed end up earning 10% over the year. But if you had another friend whom you would lend the same principal on the same turn, at the end of the year, you would receive another 10% interest payment.

If you would lend the latter friend the principal, plus the interest paid by the prior friend, you would, in fact, be earning interest-on-interest, but that is a whole other story. 

APR vs Interest Rate

Aside from the time adjustment, the APR that a financial institution will show on a loan agreement will also include any additional charges or cost of borrowing that will be added during the duration of the loan.

Additional charges can include (but are not limited to):

  • Cost of underwriting the loan
  • Broker fees
  • Fees related to invoicing
  • Other administrative costs

APR Formula

APR Calculators

There are a number of good APR calculators available online. The ones we recommend are:

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