Financial Literacy
What is APR Key Takeaways
- The APR can give you a more complete picture of a loan’s costs by factoring in fees.
- If there are no fees, the APR and interest rate will be the same.
- The advantage of a fixed APR, which many personal loans offer, is your interest rate and monthly payments are stable.
When you’re trying to make a big financial decision, it’s important to have all the facts. We can’t be too cautious when it comes to personal finance, right? If you are taking out a loan, that means understanding the annual percentage rate.
In fact, the federal Truth in Lending Act (TILA) requires lenders to give you specific disclosures about important terms, including the annual percentage rate (APR), before you are legally obligated on the loan.
What is annual percentage rate? We’ll answer your APR questions in this article.
How Does APR Work?
First, let’s break down what an annual rate is. An APR is the amount of interest and fees a lender charges, expressed as a yearly percentage. The interest rate represents the amount of interest paid on the loan amount. The APR folds that in with the other costs, such as origination fees. Essentially, it gives consumers a simple way to see the full price they will pay to borrow money. That way, it’s easier to compare different loan offers.
This shouldn’t be confused with annual percentage yield (APY), which refers to how much interest you could earn on money, like in a savings account. An APY reflects the interest rate, but also shows the effect of compound interest. That is when you earn interest on your initial principal plus any previous interest earned. Interest-bearing accounts could have daily, monthly, quarterly, or yearly compounding periods. The APY will reflect the compounding periods, and that’s why it’s helpful when comparing the returns on savings accounts. Just as with loans, the interest rate alone might not be enough.
Why Is Annual Percentage Rate Important?
The APR comes into play when you are comparing credit cards or applying for a loan.
It’s likely that you’ve seen this type of interest rate mentioned as you looked at personal loans, home loans, or applied for a line of credit with credit card companies or other financial institutions. Understanding how that rate functions and how it can be applied could help you make better decisions when borrowing money. The interest rate, as well as the APR offer, factors in things like credit scores, credit history, the size of the loan and the length of the loan. As a consumer, you may be able to obtain lower interest rates by building and establishing good credit.
When there are fees included, it is also good to know what the APR means because it reflects the total cost of borrowing money.
How to Calculate and Annual Percentage Rate
Calculating APR is simple. You will need a few numbers to get started:
- Principal loan amount
- Fees
- Interest paid over the life of the loan
- Number of days in the loan term
Let’s try an example. We’ll calculate the annual percentage on a $10,000 loan with a total charge of $4,000, which includes interest over the life of the loan and the origination fee. Additionally, let us assume the loan term is 5 years or 1,825 days.
| Steps to Calculating APR on a Loan | ||
| Step 1 | Divide the finance charge by the loan amount. | $4,000 / $10,000 = 0.4 |
| Step 2 | Multiply the result by the number of days in the year. | 0.4 x 365 days = 146 |
| Step 3 | Divide the total by the term of the loan. | 146 / 1,825 days = 0.08 |
| Step 4 | Multiply the result by 100 and add a percentage sign. | 0.08 x 100 = 8% APR |
Fixed compare to variable?
An APR can either be a variable or fixed yearly rate. Typically, fixed APRs don’t change during the life of a loan, meaning you’ll have a consistent monthly payment. Variable APRs are tied to an index interest rate, like the prime rate. If those rates increase, your APR will increase with it and so will your monthly payments.
How does this apply to personal loans?
A personal loan could come with an origination fee that would be reflected in the APR. This often is a one-time fee that is included in the principal loan amount and is deducted from the amount deposited into your bank account. The advantage of a fixed APR is your interest rate and monthly payments are stable. It’s also to your advantage to go with personal loans that use simple interest. Simple interest is calculated on the principal loan balance only. You won’t pay interest on top of your interest like you do with credit cards.
APR and mortgages
The annual percentage rate could really help when comparing mortgages, because home loans may include certain fees that don’t pop up elsewhere. An APR includes the mortgage interest rate plus things like points, closing costs, origination fees, and broker fees.
Also, it’s important to compare apples to apples, such as fixed APR vs. fixed APR. Comparing a fixed APR to a variable APR can be tricky. It could even be difficult to compare two variable-rate APRs, because the terms of the loans might be quite different. The length of time you plan to stay in the house also plays a big role in your total costs.
APR and credit cards
Many credit card companies don’t charge fees, so the APR tends to be the same as the interest rate. Both tell you how much you’ll be charged for your outstanding balance. Also, credit cards can have multiple interest rates—and multiple APRs—based on how you use the card. Here are some examples:
Purchase APR. The rate applied to purchases. If there are no fees, this would reflect the total interest paid.
Cash advance APR. The rate for borrowing cash from your credit card, which is often higher than the APR for purchases. These generally do not include a grace period.
Introductory or promotional APR. Some cards start with a lower rate for a limited time when you open a new account. These could be applied to specific purchase types, balance transfers, cash advances, or other types of transactions.
Penalty APR. This is often the highest annual percentage rate on the account. These are used if you miss a payment, make a late payment, or violate the card’s terms and conditions.
Where can you find your credit card’s Annual Percentage Rate?
Details on credit card APRs will be available by reviewing the cardholder agreement. You can also check your monthly statements to see how it was applied.
Ways to Make Informed Decisions About APR
When you’re evaluating what financial offer is best for you, it’s a good idea to do some calculations to get a better idea of how the yearly interest rate will impact your finances. Additionally, keep these important tips in mind:
- An APR and an interest rate are different. Compare them both to understand what your total cost will be in each scenario.
- Variable APRs fluctuate, meaning you will have a less consistent monthly payment. You can’t be certain of your monthly cash flow.
- A fixed APR means your payment will be stable. You’ll be able to plan better when it comes to your budget.
This article is for educational purposes only and is not intended to provide financial, tax or legal advice. You should consult a professional for specific advice. Best Egg is not responsible for the information contained in third-party sites cited or hyperlinked in this article. Best Egg is not responsible for, and does not provide or endorse third party products, services or other third-party content.
