You won’t always be able to determine which product is the cheapest by just looking at the interest rate. For instance, even though a loan with a low interest rate might seem like the ideal choice, you can still have to pay a hefty arrangement charge, making it more expensive than other loans.

The APR accounts for all of these variables and provides you with a single number that illustrates the cost of borrowing from that supplier.

Two loans, for instance, might each have an interest rate of 10%. This might mean they will both be the same price. However, Loan A may impose an arrangement fee, making it more costly than Loan B, which does not.

The interest rate does not account for any additional expenses. As a result, Loan A will have a higher APR than Loan B, indicating which loan is more affordable overall. The APR is a standardised method of displaying the cost of borrowing that makes it easier for you to compare various loans and credit products.

When applying for a loan, it’s crucial to understand the distinction between interest rate and annual percentage rate (APR) because you will need to know how much you will have to pay back overall.

The APR includes any additional costs you will be required to pay as part of the lending agreement. Simply put, interest rate is the amount you will be paid over a year for borrowing the principal amount. You typically pay off interest as part of your monthly repayments rather than in a single lump sum because interest charges are added to the total amount due. This makes it easier to budget for paying interest expenses.

While both APR and interest rates show how much you will have to pay back overall when you take out a loan, they are not the same. The APR and interest rate are the same only if there are no other fees, such as application fees or any other additional cost of borrowing a loan or credit product. 

Before you borrow any loan or think of getting a credit product, you must understand how APR is calculated. It will help you plan your finances and will also enable you to choose a product wisely. 

Overview of the Formula for Calculating APR 

The amount of your loan, the timing of your loan payments, and any additional late fees that might be applied to the overall loan repayment are all taken into account when calculating the APR.

For the purpose of calculating APR, the Financial Conduct Authority (FCA) has published a formula. The disclosed methodology only applies to compound debts. 

Here, the formula can be broken down by using the following: 

K = Identifies a particular advance of credit 

K’ = Identifies a particular instalment 

Ak= Amount of advance K 

A’k = Amount of instalment K’ 

∑ = Sum of all terms 

M = Number of advances of credit 

M’ = Total number of instalments

Components Included in APR Calculation 

Calculation of APR includes interest rate you will be charged by the loan or credit provider when you borrow credit product along with any standard fees such as loan application fee, or annual card fee (in case of a credit card). 

Examples Illustrating APR Calculation 

Consider that you wish to borrow £1,000 to repair your home. You choose to spread out this loan over a two-year period:

£1000 over 2 years, with an APR of 29.7%. That would imply you will pay £54.02 in payments each month totalling £1,296.48. 

Annual Percentage Rate is calculated differently for different credit products and also, the rate you will be offered will vary from credit provider to credit provider. 

Let us look at different types of credit products and how the APR is calculated for each one of them. 

Calculating APR for Personal Loans 

Although all lenders calculate an APR in the same way, the APR that you receive may vary depending on the lender and other factors including their internal lending standards. Lenders will consider a lot of factors when determining the interest rate they will offer you.

They will review your credit history to determine how trustworthy you are as a borrower. The riskier you are, the less likely they will be to lend you money, or if they do, the interest rate they offer you will probably be higher and vice versa.

APR is calculated for mortgage loans, credit cards and auto loans in the same way they are worked out for a personal loan. 

The amount you want to borrow, the length of time you want to borrow it for, and your credit score are just a few of the factors that can influence the APR that a lender offers you. Lenders are more likely to grant you loans with a lower APR if you have a strong credit score because they view you as reduced risk.

The APR is predicated on a number of hypotheses. For instance, while using a credit card, it is assumed that you would make regular, equal payments on the debt throughout the year.

Remember that the APR calculations do not account for any additional costs you might pay, such as those for late payments, cash withdrawals, or exceeding your credit limit.

Role of Creditworthiness in APR Calculation 

The better your credit score, the higher the chances of getting a lower APR. The lower your credit score, the higher APR you will be offered due to the associated risk of non-repayment of the loan. 

Impact of Loan Term on APR 

If you borrow the loan for a longer period of time, the APR will be high and if you wish for a shorter repayment period, the APR will be low. It is because the chances of defaulting on the repayments are reduced when the debt is paid off quickly. 

Relationship between APR and Loan Amount 

The higher the loan amount, the lower the APR and vice versa. 

If you wish to calculate the APR of your loan or any other credit product, all you have to do is enter the amount you want to borrow, the repayment period, additional charges that you have to pay for the loan, and the interest rate that you have been offered.

When comparing loans, it’s essential to comprehend APR and representative APR. Although the representative APR might offer you a basic sense of the APR that lenders may impose, you should always keep in mind that you might actually be given a larger APR than what was indicated.

You may compare borrowing costs using the APR without having to worry about being surprised by any additional costs.