When you consider borrowing money, you will encounter many unfamiliar terms such as APR, or annual percentage rate. But what is APR and how does it work?
APR is the interest rate in yearly rate terms. It’s the cost to borrow money. What it includes depends on the loan or credit card. While interest rates are important, the APR will give you an idea of how much you will pay for the loan.
What is included in the APR varies between loan products. Auto loans and mortgages charge fees that can be included in calculating the APR. Credit cards, on the other hand, have different APRs depending on the type of borrowing.
Let’s look more in depth at how APR works, how to calculate it and why it matters when considering a loan or a credit offer.
What is annual percentage rate?
In simple terms, the annual percentage rate or APR is the cost of your loan. It’s how much you pay the lender to borrow money for a defined period.
APR definition: It’s the interest rate plus any fees such as origination fees the lender may charge you to lend you the funds. This is important because it represents the true cost of taking out a loan.
Some people think interest rate and APR are the same. While that’s the case sometimes, APR tends to only include the fees to take out a loan besides the interest rate. It’s a better representation of the cost of funds than the simple interest rate.
APR vs interest rate:
The interest rate, expressed as a percentage, is the cost of borrowing funds. It’s charged on the principal loan amount. Interest rates can be fixed or variable.
The APR is the yearly rate that includes the interest rate plus other costs to borrow funds. These costs can include origination fees, broker fees, discount points, and so on. It’s also expressed as a percentage.
Don’t focus on just the APR or the interest rate when evaluating a loan or credit card. Both are important for determining if a loan is a good deal for you. It will also help you compare two products that are the same—for example two credit cards or two mortgage loans.
While APR may seem like the only number you need to consider, interest rate plays an important role. Lenders don’t base your monthly payment on the APR but on the principal balance plus the interest rate.
APR vs APY
While APR takes simple interest into account, annual percentage yield or APY goes a step further. It’s also known as effective annual rate (EAR) and takes into account the compound interest rate.
If you have a loan with a high interest rate, you will notice a greater difference between APR and APY. For loans with a lower interest rate, the difference may not be significant. The length of the compounding period can also make a difference between the two rates.
How does APR work?
The lender determines the APR since it includes fees and other costs that vary between lenders. The Federal Truth in Lending Act requires that all lenders disclose APR to borrowers in loan documents.
Here’s a quick illustration of how APR works: Let’s say you take out a car loan for $20,000 at 5.5 percent interest rate for five years. You also have $400 in loan fees added to the loan amount for a total of $20,400.
Your APR for the loan will be 6.32 percent and by the end of your loan term, you will have paid your lender $23,379.82. Even though you took out a loan for $20,000, you will end up paying your lender $3,379.82 in fees and interest by the end of the five years.
There are two main types of APR: fixed and variable. It’s important to know which of the two types of APR you have for a particular loan so you can understand the potential upsides and downsides. A fixed APR stays the same during the life of the loan. Whether interest rates go up or down has no effect on fixed-rate loans. This can make it easier to budget for your monthly payment amount. Variable APRs can fluctuate up or down depending on the prime rate. If the prime rate goes up, so will the variable APR on your loan. On the flip side, if the rate goes down, chances are your variable APR will also be lowered. While this can make it harder to budget your monthly payment, variable APR could result in lower payments.
What is a good APR?
A good APR depends on several factors. One of the most important considerations is the prevailing interest rate at this particular time. Lenders base the APR they offer on an index rate such as the U.S. prime rate published in The Wall Street Journal.
Each lender or bank charges a margin on top of the prime rate to determine the APR they will offer borrowers. Lenders offer different rates based on credit scores, payment history, and so on.
It’s important to shop around for loan products rather than going with the first offer. Two lenders can offer you different APRs on the same product, such as a mortgage, even if you apply with the same information (even on the same day).
Keep in mind that the APR differs between loan products. Don’t expect to get the same APR for an auto loan that you would get for a mortgage or a credit card.
Therefore, it’s important to look at “apples to apples” loans when comparing APRs. For example, compare two auto loans with the same loan terms and for the same amount but from different lenders. It will give you an idea of what a good APR is for your credit score and history.
How to calculate APR?
Calculating APR is not as complicated as it sounds as long as you have all the information. You can find this in the loan documents and it should include any fees associated with borrowing the funds. If a loan doesn’t have fees, use zero in place of the fees in the formula.
APR formula: APR = 100 x [ { [ (fees + total loan interest paid) / principal loan amount] / number of days in loan term} x 365]
The idea behind APR is to calculate the percentage of the principal a borrower will pay by taking into account upfront fees and other costs associated with the loan. Unlike APY, APR does not take into account compounding.
How to find financial services with good APR
Minimizing expenses and maximizing returns will help you keep more money in your pocket. This means finding loans with a good APR that cost you less out of pocket to borrow.
One of the most important factors when getting a loan is your credit history. If you plan to take out a mortgage or apply for a car loan soon, stay on top of your monthly payments. Pay down debt and show lenders you’re a good bet when it comes to extending credit.
Having multiple late payments, a high debt-to-income ratio and poor credit history are all red flags. Don’t open any new credit cards at least six months prior to applying for your loan.
Shop around and compare loan terms and APRs between lenders. This can vary from lender to lender so get quotes from a few different ones. Only compare similar products so you can get an accurate idea if this is a good APR.
Debt with a collateral such as auto loans or mortgages usually has a lower APR than unsecured loans. That’s because the lender can foreclose on the house or repossess the car if you can’t pay your bills.
When evaluating investment options, look at the yield over the last year and historic returns. Figure out if you want to do it yourself or if you would prefer someone to simplify the process and put your investing on autopilot.
Do your research before putting your money in the market and understand the risks inherent with investing. Even if past performance shows a good run, it does not guarantee a certain return on investments. Use your best judgment when evaluating both loans and investing options. You’re your own best advocate so do your research on both the company and the product before committing.
The Bottom Line
Understanding what APR is and how it works can be useful in comparing loan products. Most of us will take out a loan or apply for a credit card at some point. Learn the terminology so you can make informed decisions when signing on the dotted line.
Focus on growing your financial knowledge base so you can manage your money effectively. Remember: No one cares about your money more than you do. It’s up to you to do the research and figure out the best option for a loan or an investment.
