Here’s how APR works

If you’ve been researching a new credit card or refinancing your home loan, you’ve probably noticed that the term APR is everywhere. APR stands for Annual Percentage Rate, and it’s important to know APR on our list in terms of financial information to know.

In this article, we’ll cover the basics of APR—what it is, how to calculate it, and how to improve it—so you can become an informed borrower.

What is APR?

APR stands for Annual Percentage Rate. It represents the annual interest and associated costs of a loan by including loan-specific fees such as loan origination fees or mortgage insurance. You’ll find APRs for credit cards, auto loans, mortgages, personal loans, and most other lines of credit. In fact, because of the Truth in Lending Act (TILA), lenders are required to disclose the APR of a loan to borrowers.

Because the APR takes into account some of the costs of the loan, the APR is often a more accurate representation of the cost of borrowing than the interest rate alone.

For example, a mortgage may tout a low interest rate through a discount point but have higher fees, while another may have a higher advertised interest rate but lower fees. Interest rates alone can be misleading, so looking at the APR will allow you to more accurately compare the overall cost of the two loans.

Essentially, the higher the APR, the higher the cost of borrowing, and vice versa. While not all fees are included, APR is a good place to start comparing credit limits.

Two types of APR

There are two types of APRs: fixed APRs and variable APRs.

Just as it sounds, the fixed APR doesn’t change. The interest rate you lock in at the beginning of the loan is there for the life of the loan. Therefore, a fixed APR is more predictable than a variable APR.The effective interest rate you offer depends on market conditions (and your Credit score) at the time of loan/application.

While this rate is subject to change, the Consumer Financial Protection Bureau (CFPB) requires lenders to notify you in writing.

Variable APRs are related to index interest rates, such as The Wall Street Journal’s Prime Rate. This base rate fluctuates with economic conditions and, therefore, the variable APR fluctuates as well. Basically, when the index rate goes up, your variable APR goes up.

Most credit cards use variable APRs, and while you can find guidance on when the APR can change in the cardholder agreement, lenders are not required to notify you when the rate changes.

Credit cards also often have multiple APRs depending on the type of transaction. These different transactions also have different grace periods, which is the period between the account closing date and the expiration date during which you can pay for your purchases without penalty (also known as interest).

APR terms you need to know

There is more to know in our Credit Card 101, but check out the glossary below for a quick overview of how different transactional APRs generally work.

Each card will have slightly different terms, so it’s important to review the cardholder agreement when considering a new credit card.

Purchase APR

Purchase APR is the interest rate that applies to credit card purchases. You will avoid all this if you pay your statement in full each pay period. Most credit cards have a grace period between the end of the billing period and your payment due date. During this time, you can pay off your purchases without incurring any interest. If you do get charged during the billing cycle, the purchase APR is applied accordingly.

Balance Transfer APR

Balance transfer APR is the interest rate charged when you transfer your balance to your credit card. Some cards offer a low promotional balance transfer APR – please note that once the promotion ends, you will be charged the regular balance transfer APR for the remaining balance.

Cash Advance Annual Interest Rate

Cash Advance APR is the interest rate charged for the privilege of borrowing cash from your credit card. Usually this APR is higher than the Purchase APR and there is no grace period.

Penalty APR

Penalty APR is the interest rate charged when you breach a credit card condition, such as a late payment. Not all cards have a Penalty APR, but if they do, it’s usually the highest APR.

Introductory APR

An introductory APR is usually a very low rate for a set period of time. Just make sure you know the timeline after the promotional period ends and what the APR will be.

The difference between APR and APY

APR (Annual Interest Rate) and APY (Annual Yield) are easily confused with each other. Knowing these differences can pay you big financial dividends and save you from unexpected financial costs.

Both APR and APY are ways of showing interest rates. As we’ve already concluded, APR is the Annual Percentage Rate, which shows the total annual cost of interest and fees on a loan. APY is the annual rate of return, again combining interest and fees, but also taking into account The effect of compounding.

If you pay off interest from your loan or credit card balance each billing cycle, your APR will accurately reflect your costs. However, if you have a balance, the cost will be more than what the APR represents because you will now pay interest on the interest charged – aka compound interest. This is where APY, which already includes compound interest, becomes more helpful.

Because of this, it is often strategic for a credit card issuer or bank to choose APR or APY to represent their product. For example, credit cards often advertise APR because that rate is lower and doesn’t show the effects of compounding; it feels less expensive. Again, this is not a false statement, just a strategic statement. On the other hand, a savings account that earns you interest often sells you APY because it emphasizes the growth your money will bring.

It’s important to know that just because you see an APR doesn’t mean you’re immune to compounding.

How to calculate the cost of APR to you?

It’s important to understand how much a loan or outstanding balance on your credit card will actually cost you. Each bank has different profit margins and interest rates, but the general concept is the same.

For example, let’s say you have a credit card balance of $700 and an APR of 25.99%. Because APR stands for Annual Rate, you first need to find your daily rate by dividing APR by 365 days.

25.99% ➗ 365 days = .0712%

This means you’ll pay 0.0712% when you carry over your balance each day, which is roughly 50 cents per day for $700. While this may seem small, interest quickly starts to build. If the card’s bill is assessed on a monthly basis, take that rate and multiply it by the number of days in the month.

.0712% ✖ 31 days = 2.21%

Multiply this new monthly rate by the $700 balance carried over, and it will cost about $15.45 to hold that balance for the month.

Before opening a new line of credit, it’s worth doing some simple math like this to understand the cost of that line of credit.

What determines the APR you offer?

APR calculations typically begin with an index rate that reflects the state of the economy at the time. The credit card then adds a fee on top of what is called a deposit for using its service. This deposit is largely dependent on the cardholder’s credit score. People with good credit scores get better APRs than people with poor credit scores.Therefore, it is important to understand how Improve your credit score. There are many ways to improve your score, but here is a list of the easiest and most common:

  1. build credit
  2. Pay bills on time
  3. Keep the balance on your existing card low

Over time, these small changes can improve your credit score and reduce your overall borrowing costs.

Bottom line

Credit and loans are part of modern life, so APR isn’t going anywhere.Although you may be the type of borrower who pays your credit bill in full Every month, in your life, there may come a time when you cannot avoid paying interest in full. During these times, knowing the APR will help you become an informed borrower.

As you make these decisions, keep these key points in mind:

  • APR stands for the cost of borrowing, including interest and fees.
  • Fixed APR has a fixed interest rate during the loan process, while variable APR may change without notice.
  • APY differs from APR in that it takes compound interest into account in its calculation.
  • Improving your credit score can help you get a lower (and therefore better) APR.

Frequently Asked Questions (FAQs) about APR

If you’re still considering APR, read on to see our answers to the most frequently asked questions.

What is Simple APR?

Basically, APR (Annual Percentage Rate) is how much it costs to borrow money each year. It’s expressed as a percentage and includes the interest rate and fees you’ll have to pay to use the loan.

Is 17% APR on a credit card appropriate?

A good APR is one that is lower than the current average rate. Currently, the average APR is 14.68%, but credit card companies only offer this service to people with good credit scores. So while 17% is higher than the average credit APR, it’s still lower than many commercially available credit cards, so based on your credit score, it’s a good option.

The 24% APR means that this is the rate you will be charged for borrowing services during the year. This means that if you have an outstanding balance of $750 for a year at 24% APR, you will pay about $180 in interest. However, APR does not take into account compound interest, so this cost may be higher if you accumulate interest over the course of a year.

30% APR represents the amount you need to pay when you borrow from a lender. Although APR stands for Annual Rate, interest is usually calculated on a monthly or daily basis. A 30% APR represents a daily interest rate of 0.082% or a monthly interest rate of 2.5%.

Contributor Whitney Hansen writes for The Penny Hoarder on personal finance topics such as banking and investing. Writer Sarah Kutra contributed to this report.

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