How are effective interest rates calculated on a loan ? And how much do they affect the real cost of financing? Good questions, which, of course, you’ve asked yourself many times.
First of all, you must know that the actual interest refers to the calculation of the APR , or to the actual cost that you will go to pay on your loan.
But do not worry. In this guide, you will find the answers you are looking for. Read it all, until the end, because we have explored important concepts. Starting from the difference between Tan and Taeg and much more.
Interest on a loan. What to know
The term interests means the sum that must be repaid annually to the lender (bank or financial) against the loan received. This sum is calculated through a percentage, called “interest rate”. When calculating interest on a loan or mortgage, one must always distinguish between two different types of percentage rates: the TAN and the APR . What are they
- TAN stands for Nominal Annual Rate and represents the amount of interest due.
- The APR, on the other hand, is the acronym of Annual Global Effective Rate and includes not only the interest to pay, but also the costs related to the granting of the loan. That is: preliminary, collection and installment fees, taxes, insurance costs and the like. The Annual Effective Global Rate is precisely what allows you to know the real cost of the loan.
So here’s what APR is! This percentage rate indicates the total cost of the loan , consisting of interest and expenses. When evaluating a loan or a mortgage, you must always know and calculate the APR, not just the TAN. The amount of these two items is, however, always reported in the information sheets on the characteristics of the loan. Banks and financial companies are in fact obliged, according to the banking transparency law, to provide the customer with all the cost items related to the loan or loan . In this sense, it is always advisable to be wary of the notorious “zero interest” offers. In reality, the zero rate indicates a loan in which only the TAN is applied and not the APR. Always check the information sheet before signing it, because you may find yourself paying for cost items that you didn’t consider.
The prior consultation of the information sheet allows you to know and calculate, a priori, the APR applied on a loan. The calculation of the APR also allows you to know the actual annual cost that you will be paying on your loan.
The APR is also what you can calculate , independently, through the online forms of the same banks and financial institutions. Even if the proposed calculations are always based on simulations, they allow you to make comparisons between the various types of loans and between the various banks that offer them.
How the interest is calculated
Before subscribing to a loan or a home loan, you must compare the applied APR and always choose the lowest APR financing. But things are not always so simple, because the loan is repaid in installments and not in a single payment. The calculation of the APR, in fact, is annual and the amount of interest is repaid through monthly installments which include:
- the share of financed capital;
- the actual interest due.
So how are interests calculated?
Go to the next paragraph to find out.
How to calculate interest on a loan
The calculation of interest depends on the loan repayment plan. There are two:
- French repayment schedule
- Italian amortization schedule
The French amortization plan provides for a repayment in constant installments, in which, initially, the interest rate is higher than the principal amount.
In the French amortization plan, the APR is calculated on the financed capital. On a 10,000 euro loan, for a period of 10 years, for example, with a 7% APR, you will have a constant monthly payment of 116.11 euros, which in 12 months will amount to 1393.30 euros, while the amount annual effective interest will be 677.32 euros.
With the Italian depreciation plan instead, we have variable installments and constant capital. In this type of repayment , the APR is calculated on the residual debt at the end of each installment. Therefore, there will be different and decreasing monthly installments over time, in which the principal amount will always have the same amount, while the interest rate will be variable.
Considering the previous example, with the Italian depreciation an effective annual interest of 667.92 euros will be paid, therefore lower than the one to be paid with the French repayment plan.
Find the tools for calculating interest (including for the APR), with the various amortization schedules.
If you want to save on the cost of interest, then, you must choose not only the loan with the lowest APR, but also the one with the Italian amortization plan.
The calculation of the APR is simpler in fixed rate financing. Things become slightly more complicated in mortgages, because they are also offered with the variable rate formula. So here we are with the next question: how are the mortgage interest calculated? You can always find the answer in the next paragraph.
How to calculate mortgage interest
For reasons of convenience and to lower financing costs, banks often offer variable rate mortgages. That is: at an interest rate that varies over time and for the duration of the loan itself. In this case, the calculation of the APR on the mortgage may seem complicated, because the variable interest rates are never predictable. The variable rate is however already in itself much lower than the fixed one. Just think that on a fixed rate of 5%, the variable rate is around 1%.
In the mortgage information sheet, however, both the variable TAN and the APR are always reported. In fact, it is only the TAN that varies, not the APR , which only serves to know the other expense items that weigh on the mortgage. These items do not change, because they are linked to the administrative procedure for granting the loan. The calculation of the interest therefore takes place monthly, applying the change in interest rates for the period to the principal amount. This change is usually linked to the Euribor (average rate applied in interbank transactions) or to the ECB rate applied by the European Central Bank to other banks in the Euro area.
Actual interest on the loan is calculated by adding, at the interest rate for the period, the percentage of the spread set by the lender. For example, in the formula: total euro mortgage with floating rate (TAN) 0.65% (Euribor1M + 0.95%), the second percentage represents the fixed spread (mark-up) applied by the bank. To calculate the amount of monthly interest, it is better to add the percentage of the spread to the APR. An effective rate of 2.08% will be obtained on an APR of 1.13% and a Spread of 0.95%.
This type of calculation gives you an idea of the total cost of the loan.
The actual visualization of the costs and of the loan repayment plans, however, can be easily done through the online tool.
To find affordable mortgages, you must always choose the ones with the lowest TAN, APR and spreads . If the TAN is variable, at least Spread and APR will remain stable. It is not much, given the unpredictability of variable rates, but it is still something.