When I moved to the UK, I was surprised to see mortgages advertised for 4.9%. ICICI Bank’s HiSAVE account was offering 5.15% interest on savings. So if I borrowed at 4.9% and invested at 5.15%, I can make money for nothing!
The catch, of course, is that the mortgage was 4.9% APR. Annual Percentage Rate is the total interest you pay on the initial amount you borrow, divided by the number of years. This has nothing to do with the Internal Rate of Return, or the regular interest rate we know of.
APR is supposed to make it easy to compare loans by including the upfront fixed costs, this way you’ll what mortgage financing option is the right one for you. Personally, I still prefer the IRR calculation.
Here’s an example. Say you take a 10-year loan for 100,000 at an interest rate (IRR) of 10%, paid annually. Say in the first year you repay 10,000 of that 100,000. But you’d also have to repay the interest: 10% of 100,000, which is 10,000. So your first year payment is 10,000 + 10,000 = 20,000.
Next year, you repay another 10,000 of the loan, plus interest. But the interest is now on 90,000, since you already repaid 10,000. So your payment is 19,000. The next year, it goes down to 18,000, and so on until in the last year, you have a balance of 10,000, which you pay back with 1,000 interest.
| Year | Principal | You repay | Interest | Total |
|---|---|---|---|---|
| 1 | 100000 | 10000 | 10000 | 20000 |
| 2 | 90000 | 10000 | 9000 | 19000 |
| 3 | 80000 | 10000 | 8000 | 18000 |
| 4 | 70000 | 10000 | 7000 | 17000 |
| 5 | 60000 | 10000 | 6000 | 16000 |
| 6 | 50000 | 10000 | 5000 | 15000 |
| 7 | 40000 | 10000 | 4000 | 14000 |
| 8 | 30000 | 10000 | 3000 | 13000 |
| 9 | 20000 | 10000 | 2000 | 12000 |
| 10 | 10000 | 10000 | 1000 | 11000 |
| Total | – | – | 55000 | 155000 |
This means you’re paying an interest of 55,000 across 10 years, on a loan of 100,000. So your annual percentage rate (APR) is 5.5%. Get it?
So really, you’re not paying an interest of 5.5%. You’re paying 10%. But because you’re paying back the loan, your interest amount comes down. The APR makes it look like you’re paying less.
As a rule of thumb, the real interest rate is a little less than twice the APR.
I always got confused in IRR and APR. but this explanation is marvelous. thank you very much for this information. Cheers
Excellent explanation. This cannot have been explained in any more simpler terms/ exmaple. Thanks.
Best definition of APR and Interest rate. Thanks a lot
Anand, what’s AER?
AER’s the same as APR. It means Annual Effective Rate.
Thanks !! Nice and Clear. It can avoid some haste decisions by just looking at the APR. Till now I wasn’t sure of the difference.
Hi,
I’m investigating a case of “loan sharking.” I can calculate the simple interest charged on these loan, but I need to come up with the APR of the loans to prove “loan sharking.” All of the simple APR calculating programs I can find are based on on the term of the loan being in years, not months. Can you look at these examples and provide me with a formula to calculate the appropriate APR’s.
1. BH paid W only $425, between Aug 4, 2007 and Jan 4, 2009, on her $1,200 loan. W’s records show she owes him $1,515.52 as of Jan 4, 2009, and he has charged her $635 for “late fees” in addition to the remainder of her loan amount.
2. YH paid W only $517.88, between July 11, 2007 and Dec 27, 2008, on her $1,500 loan. W’s records show she owes him $1,610.92 as of Dec 27, 2008, and he has charged her $450 for “late fees” in addition to the remainder of her loan amount.
3. AH paid W $1009, between Aug 8, 2007 and Jan 17, 2009, on her $1,220 loan. W’s records show she owes him $806.16 as of Jan 17, 2009, and he has charged her $480 for “late fees” in addition to the remainder of her loan amount.
4. CH paid W $6,936.04, between Aug 25, 2007 and Mar 25, 2008, on her $5,550 loan. W’s records show she owes him a zero balance as of Mar 25, 2008. He charged her $155 for “late fees” on her loan amount, but “waive(d)” the final payment of $155.06.
5. DA paid W $8,269.76, between Jun 22, 2008 and Oct 6, 2008, on a $6,600 loan. W’s records shows a zero balance as of Oct 6, 2008. W charged $150 for “late fees” on the loan amount, but waived the final payment of $219.79 as a “write of for early payoff.”
I think the above example is wrong based on the description in FSA’s MCOB 10. APR is effectively an IRR assuming no early repayment and penalty fees. Hence, in your above numerical example, APR will be 10.0%.