Whether it’s mortgages, auto loans, or credit cards, you’ve likely seen APR, or annual percentage rate. By understanding how APRs work, you can make better financial decisions when borrowing money. We’ve got the lowdown.
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Defining APR
According to the Consumer Financial Protection Bureau (CFPB), an APR is the price you pay for borrowing money. In other words, it’s the yearly rate you’ll pay if you carry a balance, and it can vary from lender to lender. For example, let’s say that you have two credit cards. The APR of one card may be 10.99% and the APR of another might be 15.99%. Your credit score is taken into account by creditors when determining your APR, with a higher credit score generally resulting in a lower rate.
You may see your credit card rate fluctuate over time if you have a variable APR. Generally, variable APRs are based on some kind of index, like the prime rate, which is the lowest rate banks will lend at. The APR on your card will increase if the prime rate increases and vice versa if the prime rate decreases.
How APR Works
In the financial world, an annual percentage rate is commonly referred to as an interest rate. By taking monthly payments into account, it calculates how much of the principal you will pay each year. An APR is also the rate of interest paid each year on investments without taking into account compound interest.
As an example, there is usually a grace period for new purchases with credit cards. No interest is charged if you only make purchases and pay off your ending balance by the due date each month. In contrast, if you carry an outstanding balance on your card, you will be charged the agreed-upon interest each month.
Since 1968, the Truth in Lending Act (TILA) has required lenders to disclose their interest rates to borrowers. The interest rate on a credit card will be advertised every month. However, the APR must be clearly displayed before an agreement is signed by the customer.
APR vs. Interest Rate
There is a common misconception that interest rate and APR are the same thing. But, they are in fact, two different entities.
You will be charged an interest rate based on the principal amount of your loan. With a credit card, your balance would be the loan amount.
In contrast to interest rates, “APR is a broader measure of the cost of borrowing money,” explains the CFPB. In addition to the interest rate, other costs may apply, such as lender fees, closing costs, and insurance. For credit cards, the APR and interest rate are usually the same if there since there usually isn’t lender fees.
APR vs. APY
APY is also a term you may have heard. Despite the fact that it may seem similar to APR, it’s actually something entirely different.
An APY is an annual percentage yield. In some cases, it’s called EAR, or effective annual rate. The APR tells you how much interest you will be charged when you borrow. On the other hand, the APY/EAR tells you how much interest you will earn when you save. Because of this, APY/EAR is usually applicable to deposits, not loans.
How is APR Calculated
Depending on if you have a credit card or an installment loan, the calculation of your APR will vary. Below is a comparison of the two.
How credit card APRs work.
Credit card issuers usually base your APR on your credit score, the type of card, and how the card will be used. Although, in some cases, they may offer one rate to all applicants. Card issuers typically calculate your APR based on how risky you are as a borrower. This is a concept known as risk-based pricing.
If you don’t pay your monthly bill in full, the credit card interest rate will be applied to your balance. The daily interest rate on your credit card is calculated by dividing your APR by 365.
Suppose you carry a $5,000 average daily balance at 15.99%. In a billing cycle of 30 days, your Daily Period Rate is 0.0438% (15.99% divided by 365). Based on the formula of DPR (0.0438) multiplied by the number of days in the billing cycle (30) multiplied by the average daily balance ($5,000), the monthly interest calculation would be as follows:
(0.0438%) x (30) x ($5,000) = $65.70 of interest charges for the month.
Throughout the month, if you make purchases, your daily interest will compound daily until the statement period ends.
How installment loan APRs work.
A loan’s interest rate is how much the lender charges you for borrowing money. Also, like credit card companies, lenders determine your interest rate based on your creditworthiness. Borrowing isn’t just about interest costs, though.
It is possible, for example, for a mortgage APR to include points, which are fees paid to lenders at closing to lower the interest rate. You may also need to pay lender fees or other charges to secure the loan. An auto loan APR may take into account the dealership’s compensation.
In addition, you may have to pay an origination fee on some personal loans. This fee will be deducted from the proceeds of your loan before you receive them. It is for this reason that a loan’s APR is usually higher than its interest rate.
In short, different types of loans and costs can affect APR calculations.
Types of APR
For credit cards and loans, there are many types of APR. What’s more, different lenders offer different rates.
The following is how each type of APR works:
- Purchase APR. In simple terms, the purchase interest rate is the rate charged on purchases made using a credit card.
- Balance transfer APR. This is the APR you’ll pay when transferring a balance from one credit card to another. In most cases, it’s the same as the purchase APR.
- Promotional or introductory APR. Several credit cards offer introductory low or 0% interest rates on purchases and balance transfers to entice new customers.
- Cash advance APR. When you borrow money from your credit card, you pay the cash advance APR. Typically, it is higher than the purchase APR. Cash advances can include other types of transactions, even when you don’t actually handle cash. Exchanging dollars for foreign currency, buying casino chips, or purchasing lottery tickets are all examples of these activities. A grace period is usually not applicable to these transactions. As a result, you’ll likely begin accruing interest right away.
- Penalty APR. By missing a payment or being late with a payment, you may violate the terms of the card’s contract, causing your APR to increase for a period of time.
- Fixed APR. The interest rate for this type of loan will remain the same for the duration of the loan. When it comes to installment loans, it’s common. But when it comes to credit cards, it’s an anomaly.
- Variable APR. These fluctuate with market interest rates, so they can go up over time. Most credit cards have this type of APR, and some installment loans do too.
What Impacts Your APR?
Your APR is influenced by many factors, some of which you can control and some you cannot:
- Credit history. If you have a poor credit history, lenders may charge you a higher interest rate.
- Income. In order to determine whether you can afford additional debt, lenders look at your debt-to-income ratio (DTI). Your application may be denied if you have a high DTI.
- Fees and other charges. Lenders might charge fees on top of your interest rate, which would increase your APR.
- Prime rate. Lenders use the prime rate as a comparison when determining interest rates. It is directly influenced by the federal funds rate set by the Federal Reserve. New loans can be affected by the prime rate. But open accounts won’t, unless the APR is variable.
- Loan type. Obviously, some loans charge higher APRs than others. As an example, mortgages and auto loans typically have lower APRs. This is due to the fact that your home or car serves as collateral, which decreases the lender’s risk. Conversely, unsecured loans like personal loans, credit cards, and payday loans typically have higher interest rates.
Tips for Obtaining a Lower-APR Card
What is the best way to get a credit card with a low APR? There is no one answer that fits all. Maintaining a good credit score, however, can lead to low interest rates and other advantages as well.
Whale building or repairing your credit isn’t easy, these guidelines from the Consumer Financial Protection Bureau may help:
- Pay your bills on time and use your current card responsibly. Your credit score can be negatively affected by late payments. To ensure that you don’t forget to pay, consider setting up automatic payments.
- Don’t exceed your credit limit. In scoring models, your “maxing out” status is taken into account. According to experts, you should not use more than 30 percent of your credit limit. So, if you have a card with a $5,000 credit limit the balance should be around $1,500.
- Continually build. Your credit score is based on your credit history. In other words, the longer your credit report shows you paying your loans on time, the better your credit score will be.
- Don’t take out more credit than you need. Taking out a lot of credit in a short period of time is not a good idea. In some cases, it indicates to lenders that your financial situation has worsened, even if that’s not true.
- Keep an eye on your credit score. Every 12-months, each of the largest credit bureaus must provide you with a free copy of your credit report. In the event that you spot an error, contact the company and agency that provided the information to try to resolve it.
FAQs About APR
1. What is APR?
APR stands for annual percentage rate. It’s a calculation of a loan’s interest rate and a loan’s finance charges over time — the total cost of credit. APR accounts for interest, fees, and time. If your APR is similar to the interest rate that shows you the lender isn’t charging any additional fees.
2. Why is APR important?
If you take on a debt, it’s very important for you to understand the APR because it’s the cost of borrowing money.
Generally, you should avoid debt with high APRs since the costs could overwhelm your budget.
3. What is a good APR?
In determining a “good” APR, factors such as competitive rates in the market, the central bank’s prime rate, and an individual’s credit score will be taken into account. Many companies in competitive industries, such as car dealerships, will offer 0% APRs on car loans and leases when prime rates are low. It is important for customers to verify that these low rates are permanent or are simply introductory rates that will be replaced by higher APRs after a certain period. It is also possible that customers with particularly good credit scores will only be able to get low APRs.
4. Why is the APR disclosed?
In order to prevent companies from misleading customers, consumer protection laws require companies to disclose their APRs.
Suppose a company advertised a low monthly interest rate without disclosing its annual percentage rate. The customer could be misled into comparing an apparent low monthly rate with an apparent high annual rate. In order to provide customers with an “apples-to-apples” comparison, all companies must disclose their APRs.
5. Where can you find your account’s APR?
Account opening disclosures and monthly credit card statements contain your credit card APR. Your current APR can often be found by looking at the section about interest charges, which indicates whether it’s based on the prime rate.
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