Takeaways
- Annual percentage rate (APR) is the cost of borrowing money expressed as a yearly rate.
- Banks, credit card companies, and financial institutions are required to disclose the APR.
- APR disclosures allow consumers to compare credit products across offerings quickly.
- APR does not take compounding into account, like the Annual Percentage Yield (APY).
- APR and APY should both be analyzed when evaluating the cost of borrowing.
How Annual Percentage Rate Works
Borrowing capital from a bank or financial institution will cost you money. This cost is not just the interest rate but also includes other fees, wrapped up into a single figure known as the Annual Percentage Rate or APR. The APR of a financial product provides consumers with a consistent definition to compare the annual cost of borrowing money across different loans, mortgages, and credit products.
Let's imagine you are contemplating a loan from a highly reputable lender. The loan documents have a stated interest rate of 5%. But when you start reading the fine print in the loan agreement, you notice that in addition to the displayed 5%, you also pay for origination and processing fees and insurance costs associated with the loan. These additional expenses need to be accounted for in your APR. Their new interest rate might total up to, say, 6.5%. This higher percentage reflects the actual annual cost of the loan, including all miscellaneous fees and interest.
Smart Money -> What is the Federal Funds Rate?
APR is crucial because it gives you a clearer picture of what you will pay annually. It is defined to help you quickly compare the total cost of debt products across a suite of different lenders. Importantly, the lowest stated interest rate on a loan does not always mean that this loan has the lowest cost because it could include hidden fees and insurance costs, which dramatically increase the cost of the loan.
Knowing the APR gives you the power to make informed decisions and compare the best credit cards, mortgages, personal loans, and other credit products. The APR ensures you are not caught off guard by hidden costs.
Smart Money -> How to Open a Savings Account in 6 Steps
How Is APR Calculated?
It is paramount to know how APR is calculated to understand how much you will be paying for borrowing money. The APR is determined by combining the nominal interest rate with any additional costs or fees associated with the loan and then spreading this total cost over the loan term.
APR = (((Fees + Interest)/Principal))/n)) X 365) X 100
Legend:
Fees = Origination and Other Fees
Interest = Total Interest Paid Over the Loan Term
N = Number of Days in Loan Term
Smart Money -> How Much Money Should You Keep in Your Savings Account?
Let us break it down with a simple example. Suppose you take out a loan of $10,000 with a nominal interest rate of 5% for a year. In addition to the interest, there is a $100 loan origination fee. Here is how you would calculate the APR:
Step 1. Calculate the Annual Interest: 5% of $10,000 = $500.
Step 2. Total Costs: $500 (interest) + $100 (origination fee) = $600
Step 3. Divide by the Principal Loan Amount: $600 / $10,000 = 0.06.
Step 4. Divide by the Number of Days in the Loan Term = 0.06/365
Step 5. Multiple by 365: .000923* 365 = 0.06%.
Step 6. Multiple by 100: 0.06 * 100 = 6%.
Therefore, the APR for this loan is 6%, accounting for both the interest rate and the origination fee. It is important to note that if the loan term is less than a year, the fees are spread out over that shorter period, which can significantly increase the APR. This calculation provides a standardized way to compare the cost of different loans and credit options, giving you a clearer understanding of what you will be paying annually. Always look at the APR, not just the interest rate, to get a true sense of the loan cost.
Smart Money -> What is the Federal Reserve?
Fixed vs. Variable APR
When considering different types of loans or credit options, you will come across two main types of APR: fixed and variable. Having a clear understanding of the differences can help you make the best financial decisions. Let’s look at both:
Fixed Annual Percentage Rate
Fixed APR refers to an APR that does not change throughout the life of the loan or credit agreement. This means the interest rate and any other fees included in the APR remain constant.
Smart Money -> What is Your Debt-to-Income Ratio?
Opting for a fixed APR can provide peace of mind because your costs will not increase over time. Fixed rates are especially beneficial during periods of low interest rates when you can lock in a favorable rate for the duration of your loan.
Variable Annual Percentage Rate
Variable APR, on the other hand, can fluctuate based on an underlying index interest rate, such as the Prime Rate or LIBOR [1]. This means your APR could go up or down during the term of your loan, affecting your monthly payments and the total amount you will pay.
Smart Money -> 7 Steps to Improve Your Credit Score Quickly
Credit cards often use variable APRs, which vary as market interest rates change. While there is a potential for lower interest rates with a variable APR, there is also a risk that your rates could increase significantly.
Credit Cards APR
While many banks and credit unions will charge a fixed or variable APR, credit card companies can charge a range of APRs based on the transaction type. Here are three examples of when your credit card company will charge different APRs based on the type of transaction:
- Balance Transfers: Some credit card companies offer 0% transfer balances. A 0% APR is the best APR you can get. Credit cards with 0% transfer balances help you avoid incurring more interest charges on your credit card balances so that you can pay off your credit card balance.
- Credit Card Purchases: Credit cards usually offer a different APR for charges you make on your new credit card. Comparing APR and APY across credit card offerings will help you determine which type of credit card you should get.
- Credit Card Cash Advances: If you need cash quickly, a credit card cash advance can put money in your pocket and is effectively a short-term loan taken out against your established line of credit.
Smart Tip:
Your credit score affects the APR you are charged on your credit card. Better rates are given to customers with higher credit scores than those with lower credit scores. Try these tips and tricks to boost your credit score quickly.
APR vs. APY: What’s the Difference?
While they may look similar, there are substantial differences between the APR and APY (annual percentage yield) of a credit card or loan. Here are some critical differences:
Annual Percentage Rate
APR represents the annual rate you will be charged for borrowing money and excludes the effect of compounding interest. APR is instead based on simple interest. The APR calculation (see above) includes the total interest incurred during the life of the loan and fees like closing costs, insurance, or lender fees on borrowed capital.
APY is a representation of the cost of credit and applies to credit products like:
- Credit Cards
- Mortgages
- Car Notes
- Student Loans
- Personal Loans
Smart Money -> What is Interest: Definition and Examples
Annual Percentage Yield
On the other hand, APY considers the effect of compounding interest, showing how much interest you will earn on an investment or note over a year. For financial products offering compounding interest, the compounding periods can occur annually, semi-annually, quarterly, monthly, or even daily. The more frequently the interest compounds, the higher the APY.
APY is a representation of the amount of interest you will earn and applies to financial products like:
- High-Yield Savings Accounts
- High-Yield Checking Accounts
- Money Market Accounts
- Certificate of Deposits
Smart Money -> 9 Ways to Earn Passive Income
Is APR Required to be Disclosed?
Historically, lenders were accused of showing potential customers the lowest interest rate possible to entice prospective customers into loans what were actually high-interest loans. Customers would get surprised with higher than anticipated interest expenses and fees. To prohibit the intentional (or accidental) deception of interest rates on credit products, the Truth in Lending Act (TILA) of 1968, a federal law in the United States, mandates lenders to disclose the APR they will charge borrowers [2].
Smart Money -> Best Online High-Yield Savings Accounts
The purpose of this requirement is to provide a clear, standardized way for consumers to compare the potential costs of different credit products. By disclosing the APR, banks and other financial institutions offer a more accurate picture of how much interest consumers can expect to pay over a year. This regulation helps ensure consumers are not misled by interest rates that appear attractive at first glance.
What is a Good APR?
The best APR depends on the type of financing you are applying for. The best APR is a 0% balance transfer, but these transfers have a shelf life, and interest is usually ratcheted up after a grace period. While there is no singular definition of what constitutes a “good APR” or “bad APR”, the lower your APR, the less you must pay in interest and fees.
Smart Money -> What is a FICO score?
What APR lenders are willing to charge is largely determined by your financial situation. This is where your credit score and credit report come into play. Borrowers with a high credit score enjoy lower APR and APYs. Alternatively, if you are working to increase your credit score you might command a higher APR than other borrowers.
Smart Summary
Understanding what APR means will help you assess the best financing options available. Whether you are exploring one of the best credit cards, need a credit card cash advance, or selecting the best mortgage, comparing APRs among your options will be a useful barometer for comparability. Don’t forget to also account for APY during your vetting process to capture the full financial picture. If you don’t know where to find the APR, you can ask your lender to show you where it is in your signing documents.
(1) Consumer Financial Protection Bureau. What is the difference between a fixed APR and a Variable APR? Last Accessed February 13, 2024.
(2) Federal Register. Truth in Lending (Regulation Z). Last Accessed February 13, 2024.
