Effective Annual Interest (APR) – Overview, Calculation, Insights

In general, the Annual Percentage Rate is also known as the Effective Annual Rate. This is a key figure for the total cost of the loan in relation to the loan amount and the entire term.

The borrower should be able to determine which costs arise when using the loan and which annual charges are to be expected.

Of course, the annual percentage rate should also make it easier to compare different loan offers.

APR Composition

Interest is the most important valuation factor when applying for a loan. For this reason, it is very important to be able to compare the total costs.

The effective annual interest is calculated from the nominal interest (interest rate), the processing fees and any other costs that may arise.

Initial APR

In some cases, there are offers on the market that speak of an initially effective annual interest rate. This is always the case if the annual percentage rate can change during the term of the loan.

The applications are calculated using the same formula as is used for the effective interest rate. The only difference is that the interest rate has to be taken into account.

If the term is 10 years and the interest rate is set at 5 years, this is referred to as the initial annual percentage rate. After 5 years, the bank will renegotiate.

Calculation of the Annual Percentage Rate

How is APR Calculated?

The bank employee needs to do nothing more than entering the relevant key data into his computer and after a few seconds, the effective annual interest rate is displayed. If you want to apply for a loan, you shouldn’t always rely on it.

Sometimes it is very helpful to be able to calculate the effective interest independently. To make it easier to understand, we have illustrated the calculation of the effective annual interest rate using an example.

Some information is required to calculate the effective interest rate. Here’s an example:

  • Loan amount: 20,000 euros
  • Processing fees of the bank: 200 euros
  • Interest rate: 4.95% per year
  • Monthly rate: 325 euros
  • Payment: monthly
  • Total term: 6 years

If we now look at the calculation of the APR, we come across the following formula:

APR = (loan cost / net loan amount) x [24 / (term in months +1)]

For our example calculation, this would result in an effective annual interest rate of 5.43%.

To clarify the individual elements of the formula, we have once again explained the terms individually:

Borrowing costs: The borrowing costs are the portion that the borrower has to repay in addition to the money that is actually borrowed.

They can be calculated by subtracting the payout amount from the total repayment.

Alternatively, the credit costs can also be calculated by multiplying the installment amount by the number of term months and then subtracting the payout amount.

The credit costs include the processing fee, the interest and – if desired – the residual debt insurance.

Net loan amount: The net loan amount is the amount that remains when the total loan amount is subtracted from the borrowing costs.

Term in months: This is the term of the loan. For 6 years, the term is 72 months.

APR understanding

Even though this is the most important question before calculating a loan, there is no general answer. As already mentioned above, the annual percentage rate depends on numerous factors that are different for each borrower.

The processing fees, as well as the interest rate and possibly taken out insurance contribute to the amount of the effective annual interest.

To get a good overview of the expected costs in advance, a comparison with a professional comparison calculator or a conversation with an independent financial adviser is recommended.

Areas of Application for the Apr

The effective interest rate of the loan is always used when the total cost of a loan should be apparent at first glance.

Banks always create offers with, particularly favorable credit terms. However, these are not accessible to every borrower as there are restrictions on the part of the bank and in terms of creditworthiness.

In most cases, the banks’ favorable offers are only intended for customers who can provide faultless Schufa information. Here, the difficulty for the lending bank is particularly low and so cheap interest rates can come into play.

However, if the credit rating is not very good, the borrower must expect additional costs to offset the bank’s chance. If the credit rating is too bad, in most cases a loan is even refused.

The APR is an effective marketing tool when it comes to acquiring new customers for a bank and makes a transparent comparison of different loans possible.

Overview of Various Interest Rates in Finance

Borrowing rate, effective interest rate and nominal interest rate: what is meant by this? What are the differences?

The end consumer is sometimes overwhelmed when he has to differentiate between the different concepts of finance. Many terms are too similar, such as:

  • Interest Rate
  • Interest
  • Debit Interest
  • Annual Interest
  • Effective Interest
  • Effective Interest Rate
  • Nominal Interest Rate

and many more. In principle, it is not that difficult to remember the individual terms. For easier understanding we have explained the terms individually here:

Annual interest rate: Annual interest rates show how much interest the borrower has to pay each year. If the customer knows the annual interest rate of various offers, this can be a comparison factor for him. Nevertheless, the other costs of the loan are of course also included.

Interest Rate: This is the percentage of the pure cost of the loan. In order for the bank to lend EUR 100,000, the borrowers have to pay the money back with interest and they are calculated at the interest rate.

Nominal interest: this is just another expression for the interest rate.

Effective interest / APR: This information helps to compare different loan offers with each other. The effective interest rate indicates the total cost of a loan. This also includes the processing fees of the bank and any insurance.

What is the Difference Between the Borrowing Rate and the Apr?

The borrowing rate is an indicator of the expected costs that can arise with an installment loan.

For example, if a borrower borrows EUR 10,000 at an interest rate of 5% and repays the amount after one year, he must reimburse the bank EUR 10,500.

However, this is just the interest. In order to be able to determine the total cost of the loan, other items such as processing fees and supplementary insurance must also be included.

The APR takes on this task. As already mentioned above, it includes all costs in the calculation and can, therefore, be used as a comparison factor for different loan offers.

The cost of a loan cannot be recognized from the borrowing rate alone unless the other fees have also been factored in.

Differences Between the Nominal Interest Rate and the Annual Percentage Rate?

Since the nominal interest rate only represents the pure compensation of the bank for the granting of the loan. At the same time, it is only a synonym for the interest rate or the borrowing rate, the differences to the annual percentage rate are explained in a few words.

Anyone who has already made some installment loans knows the procedure. The first question is always about interest.

The bank employee then names a number such as 4.5 percent. The borrower can use it to calculate how much interest he has to pay for the entire term.

Unfortunately, the important indicators for additional bank fees and residual debt insurance that may have been taken out are missing here.

The APR includes these costs and provides very precise information about the total cost of the loan.

Two (at Least) Different Interest Rates in the Loan Agreement?

If you want to take out an installment loan from a bank, you should definitely find out about the costs beforehand. A professional loan agreement always has two different indicators or interest rates.

On the one hand, you find the borrowing rate and on the other hand, you also find an effective annual interest rate.

The borrowing rate indicates the basic compensation the bank requires for the loan. An amount of EUR 10,000 and an interest rate of 5% would result in EUR 500 in debit interest after a term of 12 months.

The annual percentage rate is much more precise here in order to be able to compare the various loan offers. In addition to repayment and debit interest, there are, for example, processing fees from the bank and any costs for default insurance.

The loan agreement always contains both values, on the one hand, to be able to recognize the difference between the borrowing rate and the effective interest rate, and on the other hand so that the borrower can accurately estimate and calculate the costs.

Interest Rate is Relevant for Calculating the Interest on My Loan?

When financing, it is important that the interest is set precisely beforehand. The debit interest rate is used to carry out the interest calculation. Only with it can the interest be calculated annually, per month or for the entire term.

This depends entirely on the lender bank. In some cases, loan contracts are offered with fixed interest rates, but in some cases also with a temporary interest rate structure.

If a loan is to be paid off over a period of 30 years, it often happens that the interest, for example, is only set for 10 years and then adjusted to the current market situation.

The borrower should, therefore, think carefully about which decision to make because the determination can have both positive and negative effects.

If the interest rate is fixed over the entire term and if the interest had become significantly cheaper after 10 years, for example, the higher interest would still have to be paid.

If the interest rate prevailing at the respective point in time is cheaper than at the start of the contract, the borrower saves cash from that moment, which can be invested in a higher repayment, for example.

Advantages and Disadvantages of the Apr

It is difficult to see the advantages and disadvantages of the APR. Nevertheless, we want to try to explain the positive and negative aspects clearly.

Advantages:

  • The total cost of the loan can be seen immediately.
  • Different loan offers can be compared with each other.
  • The calculation of the household budget is much easier.

Disadvantages:

  • The APR only gives the total cost.
  • Individual items cannot be broken down by this.
  • Favorable effective interest rates and thus cheap loans can lead to unwanted expenses.

Annual Percentage Rate for Financing

With the vast amount of information from our article, the borrower can surely see that the annual interest rate is not simply set. Basically, it results from the following costs:

The interest rate, in turn, depends on many different factors. This is based on the key interest rate issued by the central banks.

All credit institutions belonging to the central bank use the key interest rate to calculate their own financial products accordingly.

If the key interest rate rises, the interest for the end consumer will also become more expensive. This leads to more expensive credit and probably less investment in the long run.

The key interest rate has always been a good tool to boost the economy.

If investments decline and customers literally hold their money in their hands, a low key interest rate can help to make loans cheaper and thus more frequently used.

The processing fees depend primarily on the business policy of the respective bank. There are also serious differences here. With internet banks in particular, fees are often much lower than with a traditional house bank.

On the one hand, this is due to the much smaller staffing level that an internet bank has, and on the other, the lack of costs for ATMs and other things.

Since the customer carries out most of the tasks online himself at an Internet bank, the company can lure with favorable conditions.

If residual debt insurance is taken out, these costs are added to the annual percentage rate.

This always makes sense if an employment contract is on the brink or has been limited. Even for professions that are particularly difficult, it is certainly a good decision to take out residual debt insurance.

In the event of insolvency, the residual debt insurance covers further installments or the entire loan.