Knowing how to calculate interest rates can help you better understand your loan contract and put you in a better position to negotiate your rate with your bank.
Stated Interest Rate
The stated interest rate is the annual cost of the loan that a bank charges, expressed as a percentage. This interest rate does not take into account other costs associated with borrowing the money.
Annual Percentage Rate
The annual percentage rate (APR) is the actual amount you pay to borrow the money because it includes loan fees, closing costs, or other charges. Typically, when a bank quotes you an interest rate, it’s quoting the annual percentage rate (APR). In fact, banks must quote the APR as mandated in the Truth in Lending Act (TILA). The annual percentage rate is the total cost of credit borrowing expressed as an annual rate. The APR is a broader metric because it includes the stated interest rate as well as any additional costs charged by the lender. As a result, the APR is usually higher than the stated interest rate unless there are no fees or additional charges by the lender.
How to Calculate the Stated Interest Rate
If you borrow $1,000 from a bank for one year and have to pay an agreed $60 in interest for that year, your stated interest rate is 6%. Here is the calculation:
Stated interest rate = Interest ÷ Principal= $60 ÷ $1,000 = 6%
Your annual percentage rate or APR is the same as the stated rate in this example because there are no additional fees to consider. However, the $1,000 loan would be less favorable if you were charged $60, but you had only 120 days to repay the loan.
Interest rate = Interest ÷ Principal X Days of the Year (360) ÷ Days Loan is Outstanding= $60 ÷ $1,000 X 360 ÷ 120 = 18%
The interest rate would be 18% since you only have use of the funds for 120 days, but you’re still being charged $60 for the period.
How to Calculate the Annual Percentage Rate (APR)
Using the earlier example, let’s say you borrow $1,000 from a bank for one year and have to pay an interest rate of 6%. However, the bank also charges a $25 fee to process the loan. The stated interest is $60, as shown in the earlier example, but here’s the calculation again.
Stated interest rate = Interest ÷ Principal= $60 ÷ $1,000 = 6%
The annual percentage rate would be calculated as follows:
Annual percentage rate = (Interest + Fees) ÷ Principal= ($60 + $25) ÷ $1,000 = 8.5%
Your annual percentage rate increased to 8.5% from 6% because of the loan processing fee. This difference is why it’s important for borrowers to review and understand both the interest being charged but also any fees or additional costs added on by the lender. Although loan fees may appear innocuous at the onset of the loan, they can have a significant impact on the total cost of borrowing.
