APR: Defined And Explained

If you’ve ever applied for a mortgage or taken out a credit card, you’ve probably heard the term annual percentage rate (APR). APR is a key component of borrowing, but it can seem confusing at first. Multiple factors are used to calculate it. Understanding how APR works can help you find the best rates and become a more informed borrower.

What Does Annual Percentage Rate Mean?

The annual percentage rate represents the annual rate someone is charged to borrow money. It includes the interest rate plus any associated fees and additional costs. APR is used for mortgages, loans and credit cards. It can vary per lender, so it’s important to consider APR when shopping around for such products.

Some people may confuse APR and interest rate as the same thing. Here’s how they are different. Interest rate is the annual cost to borrow the principal balance of a loan and does not include any additional fees. The APR is the total annual cost to borrow and includes the interest rate as well as fees. That is why your APR is usually higher than your interest rate. The interest rate affects your monthly payment, not APR. The interest rate also affects APR, not the other way around.

How Does APR Work?

When someone borrows money from a financial institution, they’ll have to pay back the money they borrowed plus interest on the loan amount. They also need to pay for the work completed on getting the loan from application to closing.

The APR includes the interest the borrower must pay on the loan as well as other fees, which may include:

• The amount the lender charges for processing the loan, known as the origination fee
• Any points you pay to reduce your interest rate, also known as discount points
• Any other fees from the lender
• Mortgage insurance, if your down payment is less than 20%

Types Of APR

There are many different types of APRs. The type of APR will depend on the loan product you have (mortgage versus credit card) and the type of transaction you perform. Here are some of the main types you can expect to encounter:

• Fixed APR: A fixed APR is an annual rate that will not change throughout the loan term.
• Variable APR: A variable APR is an annual rate that can change throughout the loan term.
• Purchase APR: A purchase APR is a rate applied to all credit card purchases.
• Promotional or introductory APR: A promotional or introductory APR refers to the low rate that credit card companies often offer to new cardholders for a limited time. The goal of offering a low rate is to entice people to sign up for the card.
• Balance transfer APR: A balance transfer APR is the rate credit card companies charge cardholders when transferring their credit card balance from one card to a different one.
• Cash advance APR: A cash advance APR is the rate cardholders need to pay when withdrawing cash from an ATM using their credit card instead of a debit card.
• Penalty APR: A penalty APR is what credit card companies charge cardholders if they fail to make their monthly payments.

How To Calculate APR On A Loan

Here are the steps you’ll take to calculate the APR on a loan:

1. Calculate the total interest you’ll pay over the life of the loan.
2. Add in any administrative fees.
3. Divide that number by the loan amount.
4. Divide that number by the days in the loan term.
5. Multiply that number by 365.
6. Multiply by 100 to receive a percentage.

The Truth in Lending Act (TILA) requires lenders to provide both the interest rate and APR. That means you likely won’t have to do this calculation on your own as you shop around for the best price.

Compare both interest rate and APR when considering what lender to work with and, if you’re getting a mortgage, think about how long you plan on living in the home. Make sure you’re also comparing the same loan products. Comparing a home loan to a personal loan or a 30-year mortgage to a 15-year one would be like comparing apples to oranges.

APR Examples

Here’s an example of how some of these factors can make a difference in APR when it comes to a mortgage.

Loan A is a 30-year loan with a principal balance of $200,000 and an interest rate of 5%. The origination fee was $2,000 (1% of the loan amount) and the lender charged an additional $1,000 in other fees. Total fees were $3,000. The monthly payment is $1,073. The APR for this loan is 5.13%.

Loan B is the same loan as Loan A except for the additional fees the lender charged, which are $2,500. Total fees are now $4,500. The monthly payment is still $1,073 but the APR is now 5.2%, meaning the borrower will pay more over the life of the loan.

What Is Considered A Good APR?

What’s considered a “good” APR depends on several different factors. Current market conditions, the type of lending product you're applying for and your credit score all impact the APR. For instance, 12% would be considered a good APR on a credit card, but that percentage would not be a good rate for a mortgage.

Market conditions play a part in determining APR. That’s because lenders often take the U.S. prime rate or another standard index and adjust the interest rate according to their margins. Lenders have more control over the other factors that go into APR, like discount points and fees. That’s why it’s essential to shop around and see what different lenders are offering.

Borrowers with excellent credit can expect to receive better rates on lending products. Borrowers with lower credit scores can expect higher rates. Even though they can take out a loan with a variable APR or take advantage of the low introductory rate, they should do so with caution. This can be helpful initially, but the rate can continue to increase over time or jump to a high APR once the introductory period is over.

What Impacts Your Annual Percentage Rate?

APR is not the same for every person – even if they have the same loan through the same lender. Let’s look at some of the primary factors that can impact your APR:

• Debt-to-income ratio (DTI): Your debt-to-income ratio is the percentage of your outstanding debt compared to your monthly income. If you have a high DTI ratio, you’re seen as a higher lending risk, so you’ll likely receive a higher interest rate.
• Credit history and score: If you have a high credit score and positive lending history, you’ll receive a lower interest rate on your loan. A good credit score and history of on-time payments show lenders that you’re less likely to default on your loan.
• Down payment: If you put less than 20% down for a mortgage loan, you’ll need to pay mortgage insurance, which is calculated in your APR.
• Loan type: Some loans charge higher APRs than others – for instance, credit cards come with a higher APR than a personal loan or mortgage.
• Prime rate: The prime rate is one factor lenders use to determine their interest rates when borrowers apply for new loans. The federal funds rate largely determines the prime rate.
• Fees: Lenders can charge certain fees, which are included in the APR. Look for lenders that have lower fees than others.
• Discount points: These allow you to buy down your interest rate but can cost thousands of dollars. This cost is calculated into your APR. Ensure buying points is the right option for your financial goals.

APR And Other Interest Calculation Metrics

While APR is one of the most widely used interest calculations, there are other formulas and methods for calculating interest. Knowing these terms can provide additional insight into your loans and finances.

• Annual percentage yield (APY): This formula includes compound interest as a factor. It can be used to calculate the amount of money earned from an interest-bearing account, annualized over a year.
• Effective interest rate (EIR): EIR represents the amount of compound interest charged over a year in which no payments are made. It is often used to compare the compounding interest rates of loans with differing time frames.
• Nominal interest rate (NIR): This rate consists of just the interest paid on a loan, without including fees and other costs, as with APR.
• Daily periodic rate (DPR): This measures the interest charged at a daily rate. It is the APR divided by 365.

The Bottom Line: APR Impacts The Cost Of Borrowing

An APR is the rate you pay annually on a loan or credit card. Your APR is based on a variety of factors, including market conditions, your lender and your credit score. Securing a low APR can save you thousands of dollars over the life of your loan.