How does APR work on a loan?
In: 3
To understand the APR (annual percentage rate) you should also understand the EAR (effective annual rate.)
The APR is how banks typically state the rate to the borrower, for example, 6%. It is the minimum interest that a borrower would pay if they took out a loan at the start of the year, the bank calculated the interest to be paid at the end of the year, and the borrower pays back the loan with interest at the end of the year. When interest is only calculated once in a year then the APR = EAR.
However, banks will often calculate interest more often than once a year. In this case they will still state the APR (e.g APR =6%) and will also state how frequently interest is calculated (e.g. **semi-annually,** or **twice** per year.) Because there are **2** periods that interest is calculated in the interest in each period is 6% / **2** = 3% each period.
In this case, EAR = (1 + 3%) ^ **2** -1 = 6.09%
Due to the effect of compounding the EAR > APR if interest is calculated more than once per year.
In summary:
– APR is the amount of interest quoted by the bank.
– EAR takes into consideration how frequently interest is calculated and can tell you the actual % interest that would be paid from the borrower to the lender.
– If you were to compare two loans for which one paid the highest interest you’d compare EARs.
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