Calculating Annual Percentage Rate
Annual percentage rate (APR) is the rate of interest that an investor earns on their money over the period of a year. It's also used to express the annual cost of credit (the rate at which borrowers will have to pay back a loan).
APR is a straightforward measure enabling investors or borrowers to compare different products. Investors can see at a glance which securities offer the highest returns, while borrowers will be able to identify the most favorable loan terms.
APR is calculated using the following formula:
Where i is the quoted interest rate (expressed as a decimal) and m is the number of terms (compounded) per year.
Suppose a bank account pays interest quarterly, at the rate of 5%. APR is therefore:
- APR tends to be a little higher than the rate of interest quoted.
- Interest must be expressed as a decimal when using the formula.
- There may be other costs involved in taking out a loan, not just APR. For example, some lenders may charge arrangement fees, annual fees, settlement fees and penalties for late payment (or even for paying off the loan early).
- Lenders must provide information about APR to borrowers, so it's a good evaluative measure for comparing loan or mortgage rates.
- APR is also known as "annual percentage yield" (APY) in relation to investment.
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