Annual Percentage Rate or APR as it is called is the most effective way to calculate the cost of borrowing. One may assume that the interest that gets charged is the cost that one has to pay. This is not true. The interest is known as the nominal interest rate while the annual percentage rate also takes into account the other costs like processing fee or other charges. Normally, one misses out on taking these additional outlays into account while arriving at the actual cost of the funds borrowed.
As per the regulatory requirement set by the Reserve Bank of India, all loan amortization schedules need to carry the APR details. This is to give the borrower complete clarity on what the lending institution is going to charge. However, on account of lack of understanding this aspects largely gets unnoticed.
Let us look at an example for better understanding. Mr B picked up a personal loan for Rs 1 lakh for a period of 1 year. The personal loan interest rate to be charge was 20%. And he was to pay an EMI of Rs 20 thousand for next 12 months. However, there was a deduction of 4% against the processing fee and the amount that got disbursed into his account was Rs 96 thousand. In this situation while the nominal interest was 20% his APR turned out to be 21%.
Let us look at another situation. There are some lending institutions that charge an EMI upfront. This either gets deposited by the customer or can be deducted from the proceedings of the loan. In the above situation where Mr A borrowed Rs 1 lakh, if one EMI was deducted upfront, the APR would have shot up to 26%. So you can see how the APR changes drastically with the terms of loan being different.
The APR has to be higher than the nominal rate of interest unless there is special deal or waiver from the lending institution. The banks may offer a waiver of certain expenses that were to be incurred on the loan like the processing fee, insurance premium (asking customer to buy an insurance to cover loan amount in case of any exigency is quite common these days) or any other charge will only lead to having the APR equaling the nominal rate. But one thing is for sure that the APR will never be lower.
While the above APR calculation seem to be quite easy, it may not be the case. Since the lending service costs are spread out across the loan term which can be up to 5 years in case of a personal loan, the foreclosure of your loan may make the loan slightly more expensive than the APR communicated in the amortization schedule.
What affects the APR?
The APR gets affected and changed with the following criteria:
Loan type : The type of loan that you pick up would have an impact on the APR. For example, the much publicized interest free consumer loans charge 4 to 6 EMIs in advance apart from the loan processing fee. The APR on this segment of loan would be different from a regular personal loan.
Credit profile : Your credit profile would also have an impact on the APR. In case your credit profile does not fall into the category of an acceptable band and you are seeking a personal loan for low CIBIL score the APR could be much higher than a situation where the credit score is above 750 with impeccable repayment history.
Word of advice
Looking at only the interest is not the right way to evaluate the offer made by any lending institution.
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