How Personal Loan Works – APR Calculation with Example
Personal loans are financial instruments in which a entity (the lender, typically financial institution) grants a loan (money) to another person (the debtor). And in return, the debtor agrees to pay back the original amount plus interest, and other costs associated with the loan withing pre-defined tenure defined according to the terms established for such loan.
The terms of the loan such as interest and tenure change depends on various factors. Factors such as the amount being borrowed, the debtor’s credit history and other factors affect the terms of the loan. Depending on how qualified the person applying for credit is, it may be easier or harder to get loans with the right terms.
There are loans that review your credit record to determine your loan terms and there are other loans that do not review credit (especially financial loans that help people with bad credit). Remember to ask lenders if they will check your credit to see if they will “soft pull” your credit because they don’t damage your credit or “hard pull” which can lower your credit score.
What is Annual Percentage Rate (APR)?
The annual interest or APR is the sum of interest plus extra charges, calculated on an annual basis translated into a percentage. The annual interest depends on the amount borrowed, the duration of the loan and the extra charges.
APR Formula with Example
The formula to get the annual interest is as follows:
- Divide the cost of financing by the amount of the loan
- Multiply the result by 365 (To get the annual interest)
- Divide the result by the term of the loan
- Multiply the result by 100 to get the percentage
Example: If you get a $4,000 loan and pay $600 in interest for 12 months. How much is the annual interest?
- Divide $600 by $4,000 which gives 0.15
- Multiply 0.15 by 365 which gives 54.75
- Divide 54.75 by 365 (since the loan is for one year) which gives 0.15
- Multiply that by 100 which gives 15.00% which would be your annual interest or APR.
What defines your annual interest or APR?
The annual interest or APR is defined according to your credit record. The better your credit record, the lower the interest rate on personal loans. Your credit record depends on whether you paid your previous/existing bills on time and how many other debts you have compared to what you earn monthly. If you don’t know your credit score or haven’t reviewed it, then you can use free credit score tools online depending on your country.
Read the following list to get an idea of the annual interest or APRs you may be charged according to the credit score:
- Excellent Credit Score (670 and up): Annual interest starting at 11.99%.
- Good Credit Score (620 and up): Annual interest starting at 15.99%.
- Regular Credit Score (580 to 620): Annual interest starting at 35.99%.
- Poor Credit Score (Less than 580): Annual interest starting at 45.99%.
Note that above APR’s is just an average. Depending on each individual’s case, the APR will be calculated by the lender.