Annual percentage rate (APR) symbolizes the cost of borrowing cash for a car, home or any other purchase. From the perspective of the investor or lender, APR is the annual return. Even though APR commonly serves as a representation of cost or return, it fails to offer a whole picture of all associated costs. To understand the real cost or return related with lending and borrowing, it is important to refer to the EAR or Effective Annual Rate which shows the compound interest effect.

Interest rate is the amount of loan percentage charged on money borrowed. This is the base fee and is very important when making comparisons on the loan quotes as it directly affects payments on monthly basis.

Comparison of True and Estimated Cost

APR represents the nominal interest rate to be earned or repaid every year. For example, suppose one borrows $1,000 for a period of one year for 12 % APR, calculating the estimated interest is arrived at by multiplying 12 % by $ 1000, which results to $ 120. However, in most cases, one pays a bit more than $ 120 in terms of interest. One has to consider the EAR in order to arrive at the true interest that will be paid. EAR helps in determining not only the amount of interest to be paid on the principal but also the interest amount you will have to pay on interest owed with every payment. A loan of $1,000 with a 12 % APR ultimately results to an annual EAR of 12.22. Therefore, a total of $125.50 will be paid in interest during the year.

To determine the interest amount that one will pay every month, the total annual interest is divided by 12. The EAR calculations use a formula (1+r/n) ^nth power-1, where r is the APR and n are the number of times that the interest will be compounded every year. For instance, a car loan that has monthly payments will generally be compounded 12 times every year. Other loans can be compounded daily or quarterly. The true cost of loan can be arrived at by multiplying the EAR numbers by the loan amount.

Applications of APR and Interest Rate

APR and interest rate (EAR) are both effective comparison tools for investment opportunities and loan interest rates. The figure of APR ignores any fees on loan and therefore, it is very important for consumers to ask about these fees when applying APR. On The other hand, the EAR figure may include loan fees even though it is not always the situation depending on the loan structure.

Generally, lenders would like to make the loan interest rate to be as low as possible in order to attract more buyers. In many cases, creditors, car dealers and other dealers usually make advertisements based on APR since its value is lower compared to the interest rate. This is a skewing technique as the lenders take advantage of the fact that most people do not have the knowledge of compounded interest. On the other hand, banks together with other financial funders make use of EAR or Interest in order to make the interest look very high. This in turn encourages people to open a savings account or make investments. In the application of investments, interest rate is referred to as APY or annual percentage yield.

APR Limitations

Even though APR is useful, it still has some limitations. APR normally spread the fees paid upfront over the loan’s life. Hence the APR comparison is only accurate if the mortgage is kept for the loan’s entire life. Many borrowers move or refinance their loan and do not keep it for the entire period, the APR may make some loan seem to be better artificially.