Being aware of the cost of your loan – the total amount you need to repay to the lender – is crucial. The most important aspect of this cost is the interest rate – which is calculated on the principal amount. However, to know the total cost of your loan, you need to calculate the Annual Percentage Rate or APR which is the annualized cost of borrowing that not only includes the interest rate but also the processing fees, document or administrative fees and other charges associated with the loan disbursal.
Let’s understand APR vs Interest Rate with an example
A personal loan lender offered you a personal loan of Rs 5 lakh @ 11% p.a. with a 5-year repayment tenure. The lender charges a processing fee of 2% of the loan amount, which amounts to Rs 10,000.
If you only consider the interest rate of your personal loan
Considering just the interest rate of your personal loan, here are the approximate calculations:-
- The total interest paid would be Rs 1.52 lakh,
- EMI would be Rs 10,870 and
- The total repayment amount would be Rs 6.52 lakh
If you consider the APR of your personal loan
Considering both the interest rate and the processing fees, the APR would be 11.88%. Here are the approximate calculations:-
- Processing Fee: Rs 10,000
- Amount Disbursed: Rs 4.90 lakh (after deducting processing fee)
- The total interest cost would be Rs 1.52 lakh
- EMI would amount to Rs 10,870
- The total repayment amount would be Rs 6.52 lakh
Even though you applied for Rs 5 lakh, you only receive Rs 4.90 lakh in hand. However, you still repay Rs 6.52 lakh, making the actual cost of borrowing higher than the stated interest rate. Hence, APR gives a more accurate picture of your loan’s cost.
The common mistake usually an applicant do is choosing the personal loan offer having the lowest interest rate, ignoring the charges involved. The fees and charges also add up to the overall cost of the loan which can make an offer expensive.
Why knowing APR is important
- You can easily identify a personal loan scheme offered at lower interest rates but with higher processing fees and other charges.
- You’ll be able to know the actual cost of your personal loan.
How to get the lower interest rates on your personal loans
- Maintain a higher credit score – preferably 750 and above, as it indicates your creditworthiness. Applicants having higher credit scores are often viewed as financially disciplined and thereby have a lower chance of EMI defaults.
- Avoid applying to multiple personal loan offers in a short time, as it would lead to multiple hard inquiries, which would reduce your credit score.
- Check with your existing lender(s) as some offer preferential rates to their customers and some even offer pre-approved personal loans or instant personal loans with quick disbursals.
- Avoid frequent job changes to maintain job stability. Job stability refers to income certainty, which reduces the credit risk for the lenders and therefore the benefit is passed to the applicant in the form of lower interest rates.
Summing Up
APR is a more accurate way to compare multiple personal loan offers. For example, if two loan offers have the same personal loan interest rate but different APRs, the loan with the lower APR is usually the better deal. You can use an APR calculator online to estimate the overall cost of your loan and compare multiple offers.
