When I moved to the UK, I was surprised to see mortgages advertised for 4.9%. ICICI Bank’s HiSAVE account was offering 5.15% interest on savings. So if I borrowed at 4.9% and invested at 5.15%, I can make money for nothing!
The catch, of course, is that the mortgage was 4.9% APR. Annual Percentage Rate is the total interest you pay on the initial amount you borrow, divided by the number of years. This has nothing to do with the Internal Rate of Return, or the regular interest rate we know of.
APR is supposed to make it easy to compare loans by including the upfront fixed costs. Personally, I still prefer the IRR calculation.
Here’s an example. Say you take a 10-year loan for 100,000 at an interest rate (IRR) of 10%, paid annually. Say in the first year you repay 10,000 of that 100,000. But you’d also have to repay the interest: 10% of 100,000, which is 10,000. So your first year payment is 10,000 + 10,000 = 20,000.
Next year, you repay another 10,000 of the loan, plus interest. But the interest is now on 90,000, since you already repaid 10,000. So your payment is 19,000. The next year, it goes down to 18,000, and so on until in the last year, you have a balance of 10,000, which you pay back with 1,000 interest.
| Year | Principal | You repay | Interest | Total |
|---|---|---|---|---|
| 1 | 100000 | 10000 | 10000 | 20000 |
| 2 | 90000 | 10000 | 9000 | 19000 |
| 3 | 80000 | 10000 | 8000 | 18000 |
| 4 | 70000 | 10000 | 7000 | 17000 |
| 5 | 60000 | 10000 | 6000 | 16000 |
| 6 | 50000 | 10000 | 5000 | 15000 |
| 7 | 40000 | 10000 | 4000 | 14000 |
| 8 | 30000 | 10000 | 3000 | 13000 |
| 9 | 20000 | 10000 | 2000 | 12000 |
| 10 | 10000 | 10000 | 1000 | 11000 |
| Total | – | – | 55000 | 155000 |
This means you’re paying an interest of 55,000 across 10 years, on a loan of 100,000. So your annual percentage rate (APR) is 5.5%. Get it?
So really, you’re not paying an interest of 5.5%. You’re paying 10%. But because you’re paying back the loan, your interest amount comes down. The APR makes it look like you’re paying less.
As a rule of thumb, the real interest rate is a little less than twice the APR.