Annual percentage rate can be defined as an interest rate where all the costs associated with a loan are reflected by the interest rate for a specific time period mostly one year. The working of annual percentage rate can be well understood with the help of an example.
The annual interest rate includes the loan fees and the compound interest rate accumulated for that year. There are three common and most widely used methods of calculating annual percentage rate. These are explained as under:-
- In the first step you must compound the interest rate without considering the loan fees
- In the next step you must add fees to the due balance as this will make the total amount available for the calculation of the compound interest
- Amortize the fees as a short-term loan. This loan is due in the initial payments. The remaining unpaid balance is amortized as a second, longer-term loan.
- Though the APR can be calculated in several ways depending on theterms of the loan, the formula which includes the basic components is:
- APR = [2x Number of Payments per Year x Total Finance Charges] / [Original Loan Proceeds x Total Number of Payments + 1]
Knowing annual percentage rate is important for all the borrowers to know the actual interest, interest rate and the fees associated with the loan as the lenders offer a number of different kinds and types of interest such as different interest rate structures, points and mortgage insurance.
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