Interest rates are calculated on effective annual rates known as Annual Percentage Rate (APR). Due to the annual rate applied, this interest compounds annually. If the interest was calculated on a per month basis, it would compound every month, thereby increasing the overall liability of the amount paid as interest. Hence, the interest component under APR or an annual rate is much lesser than if it was calculated on a monthly basis. In order to understand how this works, there are various available compound interest calculators in India.

How to Calculate Interest Rate on a Loan

Converting APR to Monthly

Instead of paying out every month, the funds availed as loan has 12 months of maturity or growth period. However, for ease of calculation, the annual percentage rate is divided by the number of instalments over the year. Generally, the number of instalments is 12, however, it differs in some cases where the instalments are paid quarterly, weekly, or fortnightly. In case it is paid quarterly, the APR will need to be divided by 4 and so on. The formula is basically R/N where R is the APR and N is the number of instalments over the year.

Calculating Effective Annual Rates

Throughout the loan tenure, the maximum amount of interest is always paid in the initial period. As the loan ages, more part of the EMI payment goes towards the principal amount repayment.

If the interest on loan is calculated monthly, you will end up paying interest even on the previously assessed interest as it compounds. Due to this, the overall APR that you end up paying on your loan is in fact less than the overall interest paid on your bottom line. So, in order to know the effective annual rates, you can use the formula:

Effective Annual Rate = [{1 + (R/N)]^N}-1

Suppose Rohan gets an offer for a personal loan interest rate of 12% interest per annum loan paid on a monthly basis can be calculated in the following steps:

  1. 012/12 = 0.01
  2. 1 + 0.01 = 1.01
  3. 1.01^12 = 1.1268
  4. 1.1268 – 1 = 0.1268

Converting this answer in to percentage, it would mean an effective annual rate of 12.68% is applied on your loan. This loan interest calculator would surely help you understand how effective loan rates are assessed.

Knowing how annual percentage rate and effective rate impacts your payment and amortization schedule is extremely important. This presents to you an interesting narrative on the interest charges on your loan.

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