Whether you’re looking to buy a car, apply for a loan, or invest in a business venture, understanding what an Annual Percentage Rate (APR) is and how it’s calculated is essential because it can help you make better financial decisions and plan for your future.
An APR by definition is the amount of interest you’ll pay on a loan, credit card, or other forms of borrowing each year. The APR is the yearly rate times the number of years you’ll make payments. For example, if you have a credit card with an 18% APR and you carry a balance of $1,000 for two years, you’ll pay $180 in interest ($1,000 x .18 = $180).
So, the lower the APR, the less you’ll pay in interest and some other fees. However, it’s important to remember that the APR is just one factor to consider when comparing loans or credit cards. You also need to look at some other charges involved and the total cost of borrowing.
What Exactly Is the Annual Percentage Rate (APR)?
The annual percentage rate, or APR, is the yearly cost of borrowing money from a lending institution. It’s essentially the “price” of the loan in a sense. The APR includes the interest rate, any points or fees paid to get the loan, and amortization.
As this is something that is calculated annually, a shorter loan will typically have a higher APR than a longer one because there are fewer opportunities to make payments and reduce the outstanding balance. For example, if you take out a $2,000 personal loan with a 10% APR and repay it over two years (24 months), you would pay $177 per month. If you took out the same loan but repaid it over four years (48 months), you would pay a bit over $100 per month. But this is more of an estimate and not the final calculation.
Of course, this certainly doesn’t mean that you should take longer-term loans to lower your monthly payment, as you will be longer in debt and also likely pay much more over the life of the loan.
How Do APRs Work?
Now that you know what an APR is, let’s get you familiar with how it works.
These yearly interest rates charged for borrowing money are expressed as a percentage of the total loan amount and can be either fixed or variable. Fixed APRs stay the same throughout the life of the loan, while variable APRs can change over time due to market conditions and some other factors.
Once you get a loan deal, you will have a clearly stated APR you will need to pay. This amount will be divided by the number of months so you can calculate it easily yourself without the need for any special APR calculator. So, in order to do so, divide the interest charged per year by the number of payments made each year.
Types of APRs
There are a few different types of APRs you must be familiar with. The most common are:
- Purchase APRs. They are the interest rates charged on new purchases made with a credit card. This credit card APR will usually be higher than the balance transfer APR.
- Balance transfer APRs. These are the interest rates and fees charged when you transfer a balance from one credit card to another. The rates are often introductory, meaning they will go up after a certain period of time.
- Cash advance APRs. They are the highest type of APR and are charged on cash advances and convenience checks. If you use your credit card to get cash from an ATM, you will also be subject to this high rate.
How Are APRs Determined?
When you apply for a loan or try to get prequalified in order to get a loan deal you can expect, later on, you will get your APR as a part of your loan agreement. This percentage is determined by your lender and includes some other fees besides the interest rate.
Credit card companies, banks, credit unions, or whichever lender you choose, take your credit score into account when setting your APR. A higher credit score generally translates to a lower interest rate. And lastly, APR will also differ depending on the fact you chose a variable or fixed one. For example, credit card APR is often variable while mortgage APRs can be either fixed or variable.
APR vs. Interest Rate
Both of these rates will affect the total amount of money you will end up paying back to the lender, so it’s important to understand the difference between an interest rate vs APR.
The interest rate is simply the percentage of interest charged on the loan itself. This rate is generally fixed, meaning it will not change over the life of the loan. The APR, on the other hand, is a bit more complicated.
The APR includes not only the interest rate but also any additional fees that may be associated with taking out the loan. These fees can include things like closing costs or origination fees. The APR is designed to give borrowers a more accurate estimate of the true cost of taking out a loan.
In general, loans with lower interest rates will also have lower APRs. However, it’s important to compare both rates when shopping for a loan to make sure you’re getting the best deal possible.
APR vs. APY
APR vs APY is the cost of borrowing money from a lender, expressed as a percentage of the amount borrowed. The APR includes the interest rate, points, fees, and other charges associated with the loan.
On the other hand, the annual percentage yield (APY) is the effective annual interest rate earned on an investment, after taking into account compounding. For investments that pay interest monthly, the APY will be slightly higher than the stated yearly interest rate.
Lenders use APR to calculate the true cost of borrowing money, while investors use APY to compare different investments. When comparing loans or investments, it’s important to compare apples to apples by looking at the APR or APY.
What is a Good APR?
Knowing the meaning of APR isn’t enough to be able to spot a good deal, and you of course need to know what a good APR is in general.
While this percentage will greatly depend on the loan type you are trying to get, we can say that 5% APR is good for pretty much all types of borrowing, except maybe for mortgages. On personal loans, credit cards, student loans, and auto loans, 5% is much cheaper than the average rate.
Credit cards, for example, will much more commonly offer an APR of 10% or even higher. For mortgages, an APR can in some cases be lower than 5% but that will greatly depend on your personal situation.
The APR, or annual percentage rate, is the cost of borrowing money for one year, including interest and fees. This percentage is a good way to compare different loans because it includes all of the costs of borrowing.
Because this number will greatly influence the total amount of money you will pay back, it is quite important to be familiar with it and know how to calculate it yourself.
One of many ways to calculate the APR is to divide the total cost of borrowing by the amount borrowed. Then multiply that number by 365 to get the APR.