Difference between Simple Interest and True Annual Percentage Rate

Description: Having the basic understanding of Simple Interest and Annual Percentage Rate (APR) could save you thousands of dollars on your bank loan.

Many home loan, auto loans or business loans shoppers who are considering taking a loan are often perplexed by the differences between interest rate and annual percentage rate. You can consider the simple interest as your starting point when you decide to pay your mortgage loan while the APR is tack on associated fees. To understand these concepts, it’s better to have some definitions.

What is Simple Interest?

The simple interest is the proportion of an amount loaned that the lender charges as interest to the person that borrows the money. Don’t get it confused when you see interest rate or nominal rate, they are all the same. The terms are used interchangeably. The simple interest is normally expressed in terms of annual percentage. These interest rates are used mostly on mortgages, auto loans and personal loans; however, they can be extended to loans regarding the purchase of buildings, business, and consumer goods. Money lenders usually offer lower interest rates to borrowers with low-risk while offering higher rates for high-risk borrowers. The lender is responsible for setting the rates and competition for borrowers signifying that the lenders provide comparable numbers.

Breakdown of the Simple Interest

When a payment is made on an interest loan, such payment initially goes through the month’s interest while the balance directly goes to the principal. The interest is then paid each month completely so that it doesn’t accumulate. Nevertheless, when you borrow money, the interest rate doesn’t give you the actual cost of such borrowing. Typically, simple interest isn’t amortized where a portion of your payment goes to the principal and a portion goes to the interest whereby it’s not showing the true rate. How can I calculate a simple interest rate?

Simple Interest Rate Calculation

To appreciate how simple interest works, it is paramount to provide an example. For instance, you want to take an automobile loan with a principal balance of $15,000 with a 5% annual simple interest rate. If your payment was meant to be due on October 1 and you paid on the due date, the interest will be calculated on the 30 days in September. Your total interest for this 30 days will be $61.64 in this situation. Nevertheless, if your payment was made on September 21, the company in charge will calculate your interest based on the 21 days spend. This will drop to $41.09, giving you the opportunity of saving about $20. The formula for calculating the simple interest is:

Simple interest = Principle * Interest Rate * Number of Days elapsed

In our example above, the principle is $15,000, the rate is 5% while the number of days is 30 and 21 depending on when the interest is paid back.

Note: The simple interest rate may be variable or fixed; however, it is always expressed in terms of Percentage.

Another example: You borrow $80,000 for one year with 18% simple interest means that you’re paying 1.5% interest every month on top of the principle based on the entire principal while reducing your principal monthly but your rate was still based on the entire $80,00 on month 2 to month 12. While this reduces your principle, however, the compounding effect is to the lender’s advantage not to you since the remaining principle isn’t used for the subsequent month to calculate the new rate charges.

What is the Annual Percentage Rate?

The annual percentage rate is different from the simple interest rate in the sense that it measures a broader cost of a true loan. It reflects the interest rate in addition to other costs including discount points, broker fees, origination fees and other costs. Like the simple interest, it is expressed in percentage. The idea behind using APR is to assist consumers in understanding the tradeoffs between their interest rate and the fees paid at the closing. Typical fees included during the calculation of the APR includes Underwriting fee, Loan Processing fee, Loan discount or points, mortgage insurance premiums, application or broker fees, and loan origination fee. What differentiate APR and Simple interest rate is that it should be fully amortized. Amortization breaks down the reduced principle to calculate the next month’s rate thus reducing the rate charges as time goes as it reduces the principle. On the other hand, simple interest does reduces principle but for calculation rate are still calculated based on the entire principle from day one.

How is Annual Percentage Rate Calculated?

To calculate the APR theoretically, the lender fees incorporates directly into the interest rate previous balance. The lender interest charge is the fee required for the financing of any true loan. It is done by repaying the fees completely over the lifespan period of the loan as if there were additional payments. And then a new rate is calculated based on the reduced principle. The APR shows the true measure of the cost of the money you are borrowing over time as it reduces principle thus reducing future interest charges as well. Sometimes the APR is called effective interest rate because it reflects the true percentage of the interest you will pay every year with other additional cost as mentioned earlier. Because of this, the APR is frequently higher when compared to the simple interest rate. It may sound odd, but the example below will clarify it better. For instance, you are to calculate the APR on a $1,000 payday loan with $200 charge within 14 days. Firstly, you will divide the finance charge, which is $200 by the amount of the load ($1000). After this, you multiply the result, which is 0.2 by the number of days in a year – 365. Then multiply the total by a term of the loan, which is 14.

The math in the above example would look like this:

($200/$1000)*365/14*100 = 521.42%

Example 2

Assuming you want to borrow a loan of $1,000 with an APR of 3% spanning over 3 years. To calculate this,

For first Year Interest: 1,000 x 0.03 = 30. This is then added to the principal.

= 1030

For Second Year Interest: 1,030 x 0.03 = 30.9. This is then added to the first’s year interest.

1030+30.9 = 1061

For the third Year Interest: 1061 x 0.03 = 31.83.

1061 + 31.83 = 1092.83

Within the finance period, you will be required to pay back $1,092.83

Limitation of the Annual Percentage Rate

While there are many positives in the use of APR for your loans, it still has a downside. One of such is the fact that the loan fees paid upfront are spread throughout the period of the loan. Another limitation is that different lenders may bring up their different fees in their APR calculations for various loan programs. Which is why it is important to ask your lender what is included and not involved in the APR calculation. Depending on the compounding it will vary how your loan is calculated.

What is the key difference between the Simple Interest Rate and the Annual Percentage Rate?

In the course of analyzing the cost of a loan, it is imperative to understand what the difference is between the annual percentage rate and the interest rate. The interest rate is normally used in calculating the interest expense on the loan you took. For instance, if you decide on taking a mortgage loan of about $200,000 for a year with interest rate of 6%, the expense of your annual interest would be $12,000 or you could decide to pay a monthly fee of $1,000. Nevertheless, the case is different for APR, which is expressed in percentage and doesn’t include just the interest expenses, but other additional costs and fees incurred during the loan procurement.

In comparing these two different loans, the lender that offers the lowest interest rate is likely to provide the best value, since a huge part of the loan amount is financed at a reduced rate. However, what confuses most borrowers is the situation where two lenders are offering the same monthly payments and interest rate but using different APRs. In this situation, the lender that has the lowest APR is requesting for fewer upfront fees while offering the best deal.