A Simple Guide to Annual Percentage Rates (APR)

Published on: 12 December, 2022

Updated: 24 March, 2023

Annual Percentage Rate (APR) refers to the yearly interest charged to borrowers. It is a calculation used by lenders that  can be applied to financial products such as car loans, personal loans, mortgages, and credit cards.

Designed to help consumers calculate the cost of borrowing, APR can help a borrower make informed financial decisions when taking out a personal loan, mortgage loan, car loan, or applying for a credit card. This article will cover the concept of APR, how it can be applied, and how it differs from Annual Percentage Yield (APY) so you can make the best financial decision for your unique situation.

At a Glance

• APR is the yearly price charged for a loan.
• APR applies to loans and credit cards.
• Often confused with annual percentage yield (APY), APR reflects the cost of borrowing and does not factor compounding interest.
• Learning how APR works can empower you to make smarter financial decisions.

What is APR?

Simply put, APR is the yearly rate of interest charged on a loan or credit card. Applicable to credit cards, mortgages, and loans, APR is a calculation that can be used to compare lenders and financial products.

Though relatively simple to calculate, there are several factors to consider when applying APR to a financial product such as a loan or credit card.

How does APR work?

The simple answer to the question, “how does APR work?” depends on the type of borrowing activity and lender. An APR for a credit card can look vastly different from a mortgage loan APR.

Other factors to consider include origination fees, interest rate, and the type of APR.

The two most commonly mentioned APRs are fixed and variable. A fixed APR is a fixed rate that remains throughout the life of the loan or agreement, commonly used with mortgages or car loans. With no rate variation, the borrower pays a fixed amount on a loan every year.

Typically associated with credit cards and adjustable-rate mortgages, a variable APR can fluctuate, depending on factors such as changes in federal prime interest rate. If there is an upward surge in rate, the borrower pays more on a variable APR.

How to Calculate APR

Here’s an illustration to help you apply APR to guide your financial decisions. Please note that APR calculations vary based on the type of loan.

Let’s say you’re considering borrowing \$10,000 through a personal loan and are presented with two options.

• Loan A: \$10,000 paid over five years with a 5% simple interest rate
• Loan B: \$10,000 paid over five years with a 4.9% simple interest rate

While the lower 4.9% simple interest rate option seems like an obvious choice, you need to know the expected fees and interest to calculate the APR.

If Loan A has an origination fee of \$300 and Loan B has an origination fee of \$400, which is the more attractive option?

First, let’s calculate how much interest you would pay with Loan A at a 5% interest rate over a five-year period.

(\$10,000 x .05) x 5 = \$2,500

With \$2,500 as your total interest paid on the Loan A option, you can now add the \$300 origination fee to that equation.

\$2,500 + \$300 = \$2,800

Now you have the information you need to flesh out your APR on Loan A. Using what you know about the loan – including interest charges, fees, loan amount, and the number of days in the loan – apply the following calculation to learn Loan A’s APR.

APR = ((Interest charges + fees / loan amount)) / number of days in loan) x 365)) x 100

APR = ((\$2,500 + 300 / \$10,000)) / 1,825) x 365)) x 100

With origination fees and interest charges considered, Loan A has an APR of 5.6%.

Now, let’s calculate Loan B’s APR.

(\$10,000 x .049) x 5 = \$2,450

Now that you’ve got your fees figured out, let’s apply it to the formula:

APR = ((\$2,450 + 400 / \$10,000)) / 1,825) x 365)) x 100

Loan B’s APR is 5.7%. Although at first glance Loan A seemed like a more expensive option with a higher simple interest rate, after calculating the APR for each choice, we find that Loan B’s APR is higher. The higher the APR, the more you will pay over the life of the loan.

APR and APY

APR is sometimes confused with Annual Percentage Yield (APY) or effective annual rate (EAR), as it is sometimes called. APY reflects another way to express an interest rate, but the major difference between APY and APR is that APY accounts for compound interest, which APR does not.

The formulas used to calculate APR and APY are different, too. APR speaks specifically to the cost of borrowing money, while APY calculates the interest paid to a lender. APR represents a loan’s periodic rate, which is the interest rate given for a specific time period (e.g., one month) multiplied by the number of periods in a year.

APR is applicable to investment products such as bonds, certificates of deposit (CDs), money market accounts, and deposit accounts, but it is much more common to see interest rates on these products quoted in APY terms. The reason for this is because APY factors in interest compounding, allowing potential investors to observe the true annual return on their investment once all interest accrued during the year has been accounted for.

Whether borrowing or investing, remember that simple interest, APR, and APY all play a role in choosing financial products.

APR vs. interest rate

It’s common for borrowers to use the terms APR and interest rate interchangeably. But after the APR calculation exercise illustrated above, you now know that a quoted interest rate may not be the same as a loan’s APR, at least when it comes to loans and mortgages.

An interest rate reflects the cost of borrowing money over a defined period of time, and may be represented as daily, monthly, semiannual, or annual rates. Expressed as a percentage, an interest rate can depend on your personal credit history,  the lender you choose to work with, and whether the rate is fixed or adjustable (as seen with mortgage loans).

Interest rate is one piece of the APR puzzle and plays a key role alongside fees and other knowledge points in determining APR.

Whereas interest rates and APRs may differ in the context of a loan, the two concepts are often used interchangeably when it comes to credit cards. That’s because there is no origination fee associated with credit cards and most other fees are optional.

APR and mortgages

When applied to a mortgage loan, APR factors in the mortgage interest rate and other closing costs such as points and mortgage broker fees. It’s important to be aware of the type of mortgage loan and mortgage interest rates when comparing APRs, as an adjustable-rate mortgage loan APR will not reflect the loan’s maximum interest rate.  .

APR and deposit accounts

While APR and APY both measure interest on an annualized basis, APY can help you better understand the predicted return from a deposit account, bond, CD, or money market investment when considering the impact of the investment’s interest compounding schedule.

APR and auto loans

Like other types of loans, an auto loan’s APR includes the interest rate along with fees charged for the loan, including title and registration fees, and origination fees. When comparing auto loans, it’s important to compare APRs over interest rates alone.

APR and personal loans

Most personal loans are unsecured, meaning there's no collateral attached to them. This is why personal loans tend to have higher interest rates than mortgages or auto loans. There’s more risk involved for the lender.

An APR on a personal loan includes the interest rate along with origination fees or other charges. Borrowers should also note whether their personal loan features a fixed or variable interest rate.

APR and credit cards

Credit cards differ from loans when it comes to APR application because credit cards typically do not have fees to factor into the APR equation. A consumer will often see that a credit card’s annual interest rate and APR are nearly the same.

There are, however, different types of APRs credit card owners should be aware of. Some of the most common credit card APRs include:

• Purchase APR - The rate applied to purchases made with a credit card.
• Promotional APR - An introductory low or 0% APR on new purchases or balance transfers.
• Cash advance APR - The APR applied to cash withdrawals through a credit card. Cash advance APRs are typically higher than purchase APRs and there is no grace period.
• Balance transfer APR - The APR applied to a balance transferred from one card to another.
• Penalty APR - A higher rate applied to accounts 60 days or more behind in payments.

How do credit card companies determine their APRs?

APR varies from one credit card to another. For example, you may have one card with an APR of 14.99% and another with a lower APR of 8.99%.

How do credit card providers determine APR? Fixed APRs are influenced by a borrower’s creditworthiness. Generally speaking, the higher the credit score, the lower the APR.

When it comes to variable APRs, changes in the federal prime rate influence a borrower’s rate. The Federal Reserve evaluates the economy periodically to determine whether the rate should go up, down, or stay the same.

There is no federal law that limits how high an interest charge or APR a credit card company can assign a borrower. However, the Truth in Lending Act of 1968 mandates that lenders remain transparent when it comes to the terms and conditions of a loan, including APR.

While it’s up to you as a borrower to make sure you understand the true cost of a loan, it may be reassuring to know you are protected against misleading credit card practices.

What can increase credit card APR?

When it comes to credit cards, an APR can increase for a few reasons:

• You missed a payment. Yikes! It happens. In fact, 42 million Americans expected to miss a credit card payment in 2022. But once you miss a due date, most lenders penalize you by charging late fees and raising your APR.
• You took out a cash advance. Borrowing cash on a credit card can result in a cash advance APR, which typically has a higher rate than purchases.
• Your promotional period is over. Some credit cards offer low- or no-interest promotional periods for either new purchases or balance transfers. But once this special introductory APR window closes, the normal annual rate will kick in.
• Your card has a variable rate. If federal rates increase, you can expect a variable rate to also increase. While a higher APR is never ideal, there’s always the chance that it can go back down.

How to lower a credit card APR

With a little persuasion and negotiation, it is possible to lower credit card interest or APR.

Start by reviewing your history of monthly payments. If you’ve had a credit card for a few years without any missed or late payments, your lender will likely be more willing to negotiate. Additionally, if you’ve taken steps to minimize your risk to your lender (i.e. improved your credit score or lowered your debt-to-income ratio) you may be able to better negotiate a lower APR.

You may not have to negotiate at all. Credit card issuers occasionally offer lower APR windows for existing cardholders.

Need to take matters into your own hands? A balance transfer credit card can help you pay down debt while minimizing (or even eliminating) APR during an introductory window, allowing you to pay down your principal balance faster.

What is a good APR?

The definition of a “good” APR is relative. What may be acceptable for one borrower could prove disastrous for another. It’s also important to note that APRs are influenced by personal credit scores so some good APRs may be out of reach for those with less than flawless credit.

It should also be noted that an APR that’s good for a mortgage may not be a good APR for an auto loan. In other words, APRs should be evaluated not just by their numerical value but by the type of financial product to which they’re linked.

When trying to determine a good APR, take competing credit products into account. This means researching the terms and conditions of several credit cards before deciding on or exploring different mortgage lenders before applying.

It’s also wise to compare offers against prime rates to ensure the numbers align. And whenever possible, be intentional about improving your credit score so better APR rates become available in the future.

You may also consider taking out a loan through a family member or friend. This approach saves you the hassle of a drawn-out application process while giving you a better chance of a great APR with no extra fees and flexibility in interest rates. Working with a platform like Pigeon makes it easy to create and manage loans within your own community. Tapping your personal network for a personal loan eliminates impersonal, corporate third parties like big banks.

APR offers valuable insight

When borrowing money, it’s important to understand the full cost of a loan before committing. This includes simple interest, compounding interest, and any fees or potential penalties. A low interest rate isn’t enough. Understanding APR beyond its advertised value is part of being an informed and empowered borrower. Finding the lowest APR is borrowing at its smartest.

And as a final tip, always remember to borrow within your means. It’s better to skip borrowing entirely if you cannot pay back a loan according to its terms (even if the APR is amazing).

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