Annual Percentage Rate (APR) - True Measure of Interest Fees Charged by Credit Card Companies

Annual percentage rate (APR) is a true measure of the interest fees charged by credit card companies & banks. Annual percentage rate (APR) is the effective cost of credit which is the ratio of finance charges to the average amount of credit used in the life of the loan; this is expressed as a percentage per year. In this tutorial, we look at the calculation of APR for single payment loans & multiple instalment loans.

Single Payment Loans

A single payment loan is repaid in full on the maturity date and there are two ways of calculating APR on single loan payments: I) simple interest method and ii) the discount method. The difference between the simple interest method & the discount method is what the borrower actually receives in the form of a loan.

i) Simple Interest Method

Under the simple interest method, interest is calculated on the full original amount borrowed. The formula for simple interest is:

Note that under the simple interest method, the stated simple interest rate & the Annual percentage rate (APR) will be the same. As an example, consider Peter borrowed a single-payment loan for $5,000 for 2 years, at an interest rate of 8%. The interest charge over the life of the loan (2 years) will be:

Based on this simple interest, what will the APR be?

2) Discount Method

Under the discount method, the loan borrower tends to pre-pay all the finance charges, after which interest is determined & deducted from the amount of the loan. The discount method always gives a higher APR than the simple interest method at the same interest rate because it deducts the total finance charge (total interest paid) from the amount of the loan borrowed. Therefore:

From this calculation, we are deducting the total finance charge of $800 from the loan amount borrowed of $5,000 to arrive at the real loan amount borrowed, $4,200.

We see that the annual percentage rate is actually 9.52% and not the finance charge of 8% as we derived using the simple interest method. Thus, lenders are required to quote 9.52% interest on the loan, and not 8%.

This graph shows the effects of the APR of 8% on the $5,000 borrowed principal balance; total simple interest comes out to $800 over a period of 2 years.