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An annualized rate is a way of expressing an interest rate on a loan or investment. It involves taking the actual rate that will be paid and restating it as if the loan period were exactly one year. This is often done for loans that will last for less than a year. The idea is to make it easier to compare different loan options.
Expressing a loan's interest rate as an annualized rate can be extremely revealing. For example, a lender may offer to loan $100 (USD) for a month, with a total repayment of $105. This appears to be an interest rate of 5%, which sounds good value for a loan. However, the annualized rate would be 12 times this amount, equaling 60%. This is considerably more than most bank loans or credit cards.
The annualized rate can expose the huge profits made on some types of loans. These include so-called "payday" loans, which are short term loans usually made to people on low incomes who are struggling to live from paycheck to paycheck. Such a loan might loan $100 for a week with a repayment of $125. At first glance, the $25 cost might not appear to be exorbitant. Expressed as an annualized rate, though, this would be 25% times 52, totaling 1,300%.
In many countries, lenders are legally required to give customers details of the annualized rate they will pay. This is to allow a fairer comparison of different sources of finance. Without this requirement, customers would have to work only from the "headline" rates, which are the figures companies voluntarily use in advertising. For example, a payday loan company may advertise a flat fee for the interest charge, a credit card company may advertise a monthly interest rate, and a bank loan may list an annual rate. Companies are usually still allowed to list these details as long as the annualized rate is also detailed.
There are several different ways to calculate an annualized rate, which vary depending on how interest is taken into account. The two main ones are the nominal annual percentage rate, known as simply APR, and the annual equivalent rate, the AER. The APR is calculated as in the examples detailed above.
The AER takes into account the effects of compound interest. This reflects the fact that each period's interest charge is based on the full outstanding loan amount, which includes any interest that has already been applied in previous periods and not yet paid off. This means the borrower may be paying interest upon previous interest. The precise method for calculating AER can vary but will usually be standardized where lenders are legally required to display it.
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