What is APR?

When you were young, did you play hide-and-go-seek?

Banks like that game too.

They particularly like to hide how much they’ll charge you for borrowing from them—and what better way to hide something than through obscure terminology?

If you’ve ever borrowed money, it’s likely you’ve seen the term “APR” sprinkled on those pages upon pages of disclosures. In fact, the APR is probably just one of many things you have to take mental notes on when signing agreements to borrow. 📝

But before you sign your life away when taking on debt, it’s important to understand just exactly what you are getting yourself into. This includes comprehending the aspects of APR, what it means, and how it works. 

Plus, if you want to be like 4 in every 5 Americans who are happy with their credit card selection, it pays to fully understand APR. And we are here to help you do just that. ✅

What you’ll learn

• What Does APR Mean?
• How Does APR Work?
• APR vs. APY
• How to Calculate APR
• What Affects Your APR?
• Types of APR
• Fixed APR
• Variable APR
• The Deception of APRs
• Credit Card APR Explained

What Does APR Mean? 💭

APR is an acronym for the term “Annual Percentage Rate.” Generally speaking, APR is the interest rate on borrowed (or invested) funds viewed from an annual perspective. APR is the total cost to borrow money and is just one of many ways banks and creditors make money from a borrower.

Most of the time, APR also includes fees and additional charges linked to the transaction. Therefore, APR is a great comparison tool when shopping between different types of financial products. Additionally, APR does not take compounding interest into consideration, so you have to do a bit of math to fully understand your expenses. 

Credit cards, installment loans, personal loans, and mortgage loans all have APRs, but an APR  can function a little differently on open-ended lines of credit as opposed to close-ended notes like mortgage and installment loans. 

And considering APR is the price tag to borrow money, it is key to understand the APR you’re paying on a debt because delicate differences in these rates can save you a lot of money in the long run. For example, top-notch mortgage loans and subpar ones might have a slight APR difference, but the former cost much less than the latter. 🏷️

How Does APR Work? ❓

In 1968, the Federal Reserve Board implemented the Truth In Lending Act (TILA.) The TILA requires lenders to disclose a series of information to borrowers before extending credit, and Included in this list of required disclosures is the Annual Percentage Rate.

Therefore, financial institutions, creditors, and other lenders must disclose the product’s APR conspicuously before obtaining a signature. Some institutions even go beyond that point to disclose the APR on a borrower’s statement.

An annual percentage rate differs from an interest rate as the interest rate is the cost you will pay each year to borrow the money. Interest rates are calculated on principal balances or the original amount of money you borrowed.

An APR is much broader as it includes the other costs of borrowing money aside from the interest rate alone. So because APR includes more fees and charges, your APR is usually higher than the interest rate. 

Examples of some things included in the APR are the interest rate, points, broker fees, underwriting fees, documentation prep fees, origination fees, and closing fees. It’s also important to know that APRs may not include all of the fees associated with buying the loan. Commonly not included are costs like credit reporting, inspection, and appraisal fees.

An annual percentage rate differs from the interest rate as the interest rate is the cost you will pay each year to borrow the money. Interest rates are calculated on principal balances or the original amount of money you borrowed.

APR vs. APY ⚖️

In addition to APR, you may have also heard of the acronym APY. The difference between APR and APY is all in the last word—APY means Annual Percentage Yield. The word “Yield” is opposite of the word “Rate” in the finance world.

APR includes simple interest on an annual basis. APY, however, is calculated in a different way and takes compounded interest into account. Compounded interest is the interest you earn on interest, whilst simple interest is interest that only accrues on principal balances.

On the loan side, APY will always be higher than it’s APR. The higher the rate and the smaller the compounding periods, the more of a difference there will be between the APR and APY.

In another sense, APY is also the interest you earn, or yield, on an investment or deposit account. This differs from the APR which is the interest (and other fees) you pay on a loan. Oftentimes you will hear the term APY when referring to certificates of deposits or high-yield savings accounts.

When rate shopping for deposit accounts, you always want to ask for the APY instead of the Rate, as there will be a slight difference due to compounded interest. But just like with current mortgage rates, COVID-19 has caused the interest rates on savings products to dip to a new low. So keep that in mind when looking to yield some extra money.

How to Calculate APR ➗

Are you sitting there scratching your head wondering just how exactly to calculate APR? That’s completely understandable as APR calculations can definitely be confusing. Here’s a visual breakdown of the formula for APR calculations:

Easy enough, right? Well, honestly maybe not. We get how tough math can be.

Let’s break it down with a simple example. Let’s say you borrow a loan of $2000, with a loan term of 6 months (180 days). For this loan, you have to pay $125 in total interest plus a $50 origination fee.

1. Add the interest and fees.

2. Divide that number by the principal (the loan amount of $2000).

3. Divide that number by the number of days in the loan term. 

4. Multiply that number by 365 (days in a year).

5. Finally, multiply that number by 100 to get the APR. 

Are you still there? The APR in this particular example is 17.84%—as you can see, APRs are kind of complicated, but not that hard when you break them down.

What Affects Your APR? 🤔

When it comes to borrowing money, the creditor or lender will determine your interest rate and additional fees. This in turn will affect your APR. But, there are many factors that can influence the lender’s decision to set your interest rate.

When setting your interest rate, a lender will take your credit score into consideration. If you have a good credit rating, you are far more likely to get good rates thus getting a decent APR. If you are a credit-challenged consumer you will more than likely see a higher rate and a higher APR.

It’s important to shop around as you can compare various APRs and see your best options for low-interest loans, regardless of your credit level. One lender may offer you a lower APR than another, even if you submit your applications at the exact same time.

APRs can also differ depending on the specific type of credit you are applying for. For example, credit cards tend to have higher APRs than most installment loans.

So, make sure to compare the APR of one type of product to another. Car loan APRs will look way different than credit card APRs.

To maximize your chances of getting a good APR, it doesn’t hurt to read your credit report every now and then to get a solid idea of where you stand. After all, the better the credit, the better the APR, the less money you give to the bank.

Types of APR 🗂

It should come as no surprise that there is more than one type of APR—bankers like to complicate things, in case you didn’t know. Primarily there are two types of rates,fFixed APR and variable APR. There’s a key difference in these types and it’s important to make the distinction between the two when shopping for loans.

Fixed APR ✔️

As the name suggests, a fixed APR is a set rate that doesn’t change during the term of the loan. Fixed APRs are not tied to any specific index rate and therefore are guaranteed over the loan’s life. They are much better for budgeting because of this and this is why most of the best mortgages for subpar credit have fixed rates.

Mortgage loans, installment loans, and personal loans are good examples of accounts with fixed APRs. Currently, when shopping for mortgage loans, fixed APRs will be in your best interest because of the low rates. And because of the stability of the market, today’s fixed-rate mortgage rates continue to remain at a steady low. 

Variable APR 📉

Variable APRs are different from Fixed APRs in that they have a connection to an underlying index rate. This means that variable APRs vary over the life of the loan. For example, a variable APR may be tied to a rate like the prime rate published in the Wall Street Journal. If this rate increases, so does your variable APR.

There are advantages and disadvantages to variable APR because of these fluctuations. If interest rates are on a steady down-trend, obtaining a variable APR may be in your favor. But, if interest rates are to rise then your APR will too. Variable APRs can end up being more costly in this case. 

Interest rates are pretty low now, so it is unlikely they will go any lower, making variable APRs riskier than fixed ones. The most common type of account with variable APRs are credit cards or variable rate personal loans, such as private student loans.

The Deception of APRs 🤥

Like a lot of things in life, and sometimes in the finance world, APRs can be a little bit deceiving. The major disadvantage of APRs is the fact that they don’t always accurately reflect the total cost of borrowing. Actually, APRs can sometimes downplay the true cost of the loan. 

The big reason this can happen is that APR calculations are based on the assumption of a long-term repayment schedule. Therefore, if you pay off the loan earlier or have a shorter repayment period, there may be misrepresentation in the cost and fees in the APR. 

A good example of this is the cost of mortgage loans. Mortgage closings costs are much smaller when those costs are calculated over a 30 year period as opposed to a 10 year period. So, if you plan on staying in your home for many years, it is wise to choose a loan with the lowest APR. 🏠

With the lowest APR, you will end up paying much less to finance the home. In current times, there is good news for homebuyers with long-term living intentions. The historically low rates make it even easier to get a low-APR mortgage loan. 

On the flip side, if you don’t plan to stay in the home very long, consider paying fewer upfront fees to get a higher interest rate and APR. With a higher rate, the total cost will be less in the short run. You can also purchase discount points to lower the rate, just prepare to do some intense calculations.📏📐

How Does Credit Card APR Work? 💳

When it comes to credit cards, APR is a whole new ballgame. With most types of loans, you will have one set APR at either a fixed or variable rate.

With credit cards, you can have a variety of types of APRs on the same account based on how you use the card. These types include purchase APR, cash advance APR, penalty APR, and introductory APRs.

• Purchase APR: This is the standard APR that applies to normal purchases you would make at your grocery store or restaurant.

• Cash Advance APR: This is the cost of borrowing, or advancing, cash from your credit card. This tends to be higher than on normal purchases. It’s important to check with your issuer to see if there are different APRs for checks vs. certain types of cash advances.

• Penalty APR: Occurs whenever you violate specific card terms and conditions, such as neglecting to make the minimum payment on time. In most cases, a penalty APR is the highest APR—penalty rates are somewhere between 20% and 30% on average. 

• Introductory APR: Also known as a promotional period, this type of APR is a time-bound offer usually given upon opening a credit card. It’s a good way for issuers to draw in new customers by offering a low, or sometimes 0%, APR on purchases. It can apply to specific transactions, all transactions, balance transfers, or cash advances.

The variety of APRs on credit cards can return some big bonuses if you are responsible. Credit cards with rewards systems, dollar matches, and introductory APRs can oftentimes give you some sweet deals.

But, because credit cards have higher APRs, with the country-wide average being 16.28%, it can be very easy to dig yourself into a deep hole of debt if you aren’t careful.

It’s important to remember to use your card responsibly and to pay your balance off at the end of every month to avoid getting into trouble. Using your credit card responsibly will also return the best results for improving your credit rating. 

About the author

Summer Nevins

LinkedIn Email

Summer is a banking professional and business school graduate turned expert finance writer. Raised in a small low-income town in the southern United States, Summer, like a lot of millennials, learned the ropes of personal finance the hard way. Both her work and life experiences led to discover her true passion for educating others about the complicated field of finance. Summer currently resides in the Greater Nashville Tennessee area with her husband. When she’s not writing, Summer enjoys exploring the beautiful world and hiking all of the challenging trails along the way.