Here’s how the annual percentage rate works
Editor’s Note: This story originally appeared on The Penny Hoarder.
If you’ve researched new credit cards or considered refinancing your home loan, you’ve probably noticed the term APR popping up everywhere. APR stands for “annual percentage rate” and, in terms of financial information you need to know, understanding APR is pretty high on our list.
In this article, we’ll go over the basics of APR – what it is, how to calculate it, and how to improve it – so you can be an informed borrower.
What is APR?
APR stands for Annual Percentage Rate. It represents the annual interest and associated costs of a loan including loan-specific fees such as loan origination fees or mortgage insurance. You’ll find APR listed for credit cards, car loans, mortgages, personal loans, and most other lines of credit. In fact, lenders are required to disclose the APR of a loan to the borrower thanks to the Truth in Lending Act (TILA).
Because the APR takes into account some of the costs of a loan, the APR is often a more accurate representation of the cost of borrowing than the interest rate alone.
For example, one mortgage may advertise a low interest rate through cash back points but have higher fees, while another may have a higher advertised interest rate but lower fees. Interest rates alone can be misleading, so looking at the APR will allow you to more accurately compare the overall cost of these two loans.
Essentially, the higher the APR, the higher the cost of borrowing and vice versa. Although not all fees are included, the APR is a good starting point for comparing lines of credit.
The two types of APR
There are two types of APR: fixed APR and variable APR.
Just as it seems, the fixed APRs do not change. The rate you locked in at the start of the loan stays with you for the duration of the loan. As a result, fixed APRs are more predictable than variable APRs. The actual rate you are offered depends on market conditions (and your credit score) at the time of the loan/application.
Although this rate may change, the lender is required by the Consumer Financial Protection Bureau (CFPB) to notify you in writing.
Variable APRs are linked to an indexed interest rate, such as the Wall Street Journal prime rate. This underlying rate fluctuates with economic conditions and therefore the variable APRs also fluctuate. Basically, when the indexing rate increases, your variable APR increases.
Most credit cards use varying APRs and although you may find guidelines in the cardholder agreement as to when the APR may change, the lender is not required to notify you of when the exchange rate.
Credit cards also often have multiple APRs depending on the type of transaction. These different transactions also have different grace periods, a period between the account closure date and your due date when you can repay your purchases without penalty (i.e. interest).
APR terms you need to know
There’s more to our Credit Card 101 to understand, but check out the glossary below for a quick overview of how different transactional APRs typically work.
Each card will offer slightly different terms for each, so it’s important to check the Cardholder Agreement when considering a new credit card.
Purchase APR is the interest rate applied to purchases made on the credit card. If you pay your statement in full each pay period, you’ll avoid all of this. Most credit cards have a grace period between the end of the billing period and the date your payment is due. During this period, you can refund the purchase without incurring interest. If you maintain a charge on the billing cycle, the purchase APR is applied accordingly.
APR balance transfer
Balance Transfer APR is the interest rate charged when you transfer a balance on your credit card. Some cards offer low promotional balance transfer APRs – just be aware that once the promotion ends, you will be charged the regular balance transfer APR on the remaining balance.
APR cash advances
Cash Advance APR is the interest rate charged for the privilege of borrowing money from your credit card. Normally this APR is higher than the purchase APR and there is no grace period.
The APR penalty is the interest rate charged when you violate the terms of the cards, such as making a late payment. Not all cards have a penalty APR, but if they do, it’s normally the highest APR.
Introductory APRs are normally very low rates that apply for a set period of time. Just make sure you know the timeline and what the APR will be after the promotional period ends.
The difference between APR and APY
APR (Annual Percentage Rate) and APY (Annual Percentage Return) are easily confused. Knowing the differences can pay you big financial dividends and save you from unforeseen financial costs.
APR and APY are ways to demonstrate interest rates. As we have seen, the APR is the annual percentage rate and indicates the combined annual cost to you of the interest and fees of a loan. APY is the annual percentage return and similarly combines interest and fees, but also takes into account the effects of compound interest.
If you pay off interest on your loan or credit card balance each billing period, your APR will be an accurate representation of your costs. If you have a balance, however, the cost will be more than what the APR represents, because you will now be paying interest on the interest you have been charged, i.e. compound interest. This is where the APY, which already includes compound interest, becomes more useful.
For this reason, a credit card issuer or bank is often strategic in choosing APR or APY to represent their product. For example, a credit card will most often advertise the APR because this rate is lower and does not show the effects of compound interest; it may seem like a lower cost. Again, this is not a misrepresentation, just a strategic representation. On the other hand, a savings account that earns you interest will often offer you the APY because it emphasizes the growth your money will make.
The important thing to know is that just because you see the APR does not mean you are free from the effects of compound interest.
How to calculate the cost of APR for you
It’s important to understand how much a loan or an outstanding balance on your credit card will actually cost you. Each bank has different margins and interest rates, but the overall concept is the same.
For example, suppose you have a balance of $700 on your credit card with an APR of 25.99%. Because the APR represents an annual rate, you must first find your daily interest rate by dividing the APR by 365 days.
25.99% ÷ 365 days = 0.0712%
This means that each day a balance is carried over, you are charged 0.0712%, which for $700 is about 50 cents per day. Although this seems small, interest quickly begins to grow. If the card bill is assessed monthly, take that rate and multiply it by the number of days in the month.
0.0712% × 31 days = 2.21%
Multiply that new monthly rate by the $700 balance carried over, and maintaining that balance will cost about $15.45 that month.
Before opening a new line of credit, it’s worth doing some simple math like this to understand the cost of that credit.
What determines the APR offered to you?
APR calculations often start with an indexation rate that reflects current economic conditions. Credit cards then add a fee on top of that called a margin for using their service. This margin is highly dependent on the cardholder’s credit score. People with good credit scores are offered better APRs than those with bad credit scores. For this reason, it is important to understand how to improve your credit score. There are many ways to increase your score, but here is a list of the simplest and most common:
- Establish credit.
- Pay your bills on time.
- Keep your existing card balances low.
Over time, these small changes can improve your credit score and reduce the overall cost of borrowing.
Credit and loans are part of modern life, so APR is not going anywhere. While you may be the type of borrower who pays your credit bill in full each month, there may be times in your life when you just can’t avoid paying the interest completely. In times like these, understanding APR will help you be an informed borrower.
And when making those decisions, here are the key takeaways:
- The APR represents the cost of borrowing credit, including interest and fees.
- Fixed APRs have a fixed interest rate for the term of the loan, while variable APR rates can change without notice.
- APY is different from APR in that it takes compound interest into account in its calculations.
- Improving your credit score can help you receive a lower, and therefore better, APR.
Frequently Asked Questions (FAQ) About APR
If you’re still thinking about APR, keep reading to see our answers to these most frequently asked questions.
What is APR in simple terms?
Basically, the APR (annual percentage rate) is how much it will cost you each year to borrow money. It is expressed as a percentage and includes the interest rate and fees you will need to pay to use the loan.
Is 17% a good APR for a credit card?
A good APR is lower than the current average interest rate. Currently, the average APR is 14.68%, but credit card companies only offer it to people with good credit scores. So while 17% is higher than the average credit APR, it’s still lower than many marketed credit cards, so based on your credit score, it’s a decent option.
What is an APR of 24%?
An APR of 24% means that is the interest rate you will be charged during the year for the service of borrowing money. This means that if you keep an outstanding balance of $750 for one year with an APR of 24%, you will pay around $180 in interest. The APR does not account for compound interest, however, this cost may be higher if you accrue interest during the year.
What does 30% APR mean?
A 30% APR represents the amount of money you will pay to borrow money from a lender. While the APR represents an annual rate, interest is often applied monthly or daily. An APR of 30% represents a daily interest rate of 0.082% or a monthly interest rate of 2.5%.
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