Credit allows you to receive something in the present in exchange for a promise to pay for it in the future. Credit lets you take out a loan to purchase a house, use an installment plan to buy a refrigerator and rely on a student loan to pay for a data analytics class, for example. The strings attached to credit come in the form of interest you must pay on the loan until you pay back the principal in full.
If you want to borrow money, you should first figure out the cost of doing so. The Truth in Lending law requires a lender to tell you the cost of taking out a loan. This written disclosure must include the annual percentage rate (APR) and the finance charge.
Once you have the APR, calculating a daily interest rate is a simple process.
APR vs. the Finance Charge
A finance charge is the total dollar cost of using credit. The charge includes the interest costs, service charges and any credit-related insurance premium. For instance, if you borrow $100 for a year, the interest on the loan might be $10, but you might also pay a service charge of $1, so the finance charge is $11.
In contrast, the annual percentage rate is the relative cost of credit over a year's time. Using the prior example, assume you borrow $100 for one year and pay a finance charge of $10. If you keep the $100 for the entire year and pay the $110 at the end of the year, your APR is 10 percent. If, however, you pay the $110 in 12 monthly installments, you don't have access to the $100 for the entire year and your annual percentage rate is 18 percent.
What Is an APR?
The annual percentage rate is the interest that a borrower pays a lender for the use of a certain dollar amount for a specific time. Expressed as a percentage, an APR is the cost of borrowing a principal amount for a loan's term. From the lender's view, APR is the income she earns on the loan, which is in addition to fees or additional transactional fees the lender receives.
The annual percentage rate does not incorporate the compounding of interest. Instead, it's a flat rate a consumer uses to compare one loan alternative with another.
Benefits of Knowing APR
Once you have the APR, you can compare the value of the asset you're acquiring using borrowed money to the benefits you expect to receive from the asset in question. You can also determine whether a high interest rate might put your ability to meet other budget obligations at risk.
Calculation of APR
To calculate an APR, multiply the periodic interest rate by the number of periods for which the periodic rate is applied to the outstanding balance each year, not the number of times an interest rate is applied to a loan's balance:
APR = (((Fees + Interest)/Principal)/N) x 365) x 100
- Interest = The interest paid over the loan's term
- Principal = The loan amount
- N = The number of days in a loan period
APR to Daily Periodic Rate
The daily periodic rate is the interest rate that a lender charges on a daily basis on a loan's outstanding balance. To calculate the daily periodic rate, you divide the APR by 365. Using the example provided above, divide the 10 percent APR by 365, which equals 2.739 percent.
To comply with the Truth in Lending law, a lender must provide you a document that tells you the cost of a loan in terms of its annual percentage rate and other finance charges. Once you have this cost of capital, you can calculate the loan's daily periodic rate from the APR.