If you’ve applied for a loan or credit card before, you’ve probably come across the financial term APR, or annual percentage rate. You typically see APR advertised with credit card products.
Understanding how APR works is essential when taking out a loan or a line of credit, because it can help you calculate the best rate.
In this article, you’ll learn everything you need to know about APR.
What Is APR?
The annual percentage rate is what a lender charges you to borrow money on a yearly basis. This includes the interest rate plus any additional fees.
APR is the total cost a lender charges you to borrow money.
How does APR work?
An annual percentage rate is typically calculated annually and the borrower pays for the fees monthly.
Many lenders also offer an introductory APR, which is a grace period where a borrower often doesn’t have to pay APR fees. Often, companies will advertise a 0% APR during this introductory period with the goal of getting new customers in the door.
The tactic here is to entice new customers to rack up charges or transfer a balance over. Then, after the grace period is up, the borrower will be responsible for paying APR and potentially other fees.
Also, if you don’t pay off your balance during the introductory period, you could easily have to pay hundreds or thousands of dollars in fees, depending on your balance and the terms of the agreement.
What is a good APR?
As for how much APR lenders charge, it usually depends on the borrower’s credit score. Borrowers with excellent credit will likely pay a lower rate, while those with fair and poor credit will likely pay much higher APR fees.
Credit card APRs can also vary depending on the type of charge. For example, a lender may charge a higher cash advance APR than they would for purchases or balance transfer. A borrower may also have to pay a high-rate penalty APR for late payments or other violations in the cardholder agreement. This can affect your credit score, so be careful.
Types of APR
Credit cards or loan amounts typically come with either a fixed-rate or variable APR.
On fixed-rate loans, interest rates stay the same for the entirety of the loan’s term. This means that the cost of borrowing money stays constant throughout the life of the loan and won’t change with fluctuations in the market.
For an installment loan like a mortgage, car loan or personal loan, a fixed rate allows the borrower to have standardized monthly payments.
One of the most popular fixed-rate loans is the 30-year fixed-rate mortgage. Many homeowners choose the fixed-rate option because it allows them to plan and budget for their payments. This is especially helpful for consumers who have stable but tight finances, as it protects them against the possibility of rising interest rates that could otherwise increase the cost of their loan.
Auto loans are usually only available with a fixed rate, although specialized lenders and banks outside of the U.S. sometimes offer a variable rate option.
Calculating the cost of a fixed-rate loan
Let’s say you take out a $20,000 auto loan at a 7.5 percent fixed APR for five years with no additional fees.
Assuming you make all the payments on time, you’ll have paid $24,000 total: $20,000 for the original loan, and $4,000 in interest charges.
A variable rate loan has an interest rate that adjusts over time in response to changes in the market. Many consumer loans come with a variable rate, such as student loans, mortgages, and personal loans.
One of the most popular variable rate loans you will find is the 5/1 adjustable-rate mortgage, which has a fixed-rate for the first 5 years and then a variable rate thereafter.
Most variable rate consumer loans are tied to one of two benchmark rates, either the London Interbank Offered Rate, or the prime rate. Simply put, these two benchmarks serve as an easy way for financial institutions to determine the value of the money they are lending.
Lenders use LIBOR and the prime rate as baselines for variable rate loans, adding a margin on top of the benchmark rate to calculate the rate received by a consumer.
Credit cards are a different story. By paying your credit card balance on time each month you can avoid interest charges entirely. In this case, your APR calculation doesn’t increase the cost of borrowing. This is ideal for keeping your credit card interest to a minimum.
Calculating the cost of variable rate loans
Out of the gate, variable rate loans tend to have lower interest rates than fixed versions, in part because they are a riskier choice for consumers. Later on in the loan term, rising interest rates can greatly increase the cost of borrowing, and so, consumers who choose variable rate loans should be aware of the potential for increased interest fees.
However, for consumers who can afford to take more risk, or who plan to pay their loan off quickly, variable rate loans might be the right choice.
Like other forms of debt, the margin and interest rate that a borrower receives on a variable rate loan depend heavily on credit score, the lender, and the type of loan product.
In the case of credit cards, interest charges are usually calculated using a daily periodic rate (DPR) applied to the average daily balance (ADB) and weighted for the number of days the DPR was in effect.
Here are some other common types of APRs that you can have access to as a borrower as well.
Balance Transfer APR
When you transfer a balance from one credit card issuer to another, you will most likely pay a balance transfer APR, which is a special interest rate that applies to the total amount of your transfer.
In some cases, you can avoid balance transfer APRs if there is a special introductory period.
A purchase APR is a rate that a lender charges on credit card purchases made within a monthly billing period.
Remember that when you make a new purchase on a credit card, you will have to pay a fee on any outstanding balances that you don’t pay off.
That said, if you are responsible at paying off your balances on time, you can rack up some decent credit card rewards, while also bolstering your credit report.
How is APR Different From APY
You may be wondering about the term APY, which stands for annual percentage yield. APY is the total amount of interest you can earn annually. Be careful not to confuse APY with APR.
Here’s an easy way to distinguish between the two: APY is interest you can earn on deposits, while APR is interest that you pay on a loan.
As mentioned above, there are two types of interest rates; simple and compound. While APR is a flat, simple interest rate, APY, or annual percentage yield, includes a compound interest rate.
With compounding interest, your interest can also earn interest. For example, if your HYSA pays a 1.0% APY, a $10,000 deposit would earn $100 in interest over the course of that year (assuming the balance stays constant).
The next year’s APY would then based on your balance of $10,100, and so your earnings would be $101 during that compounding period, leaving you with a balance of $10,201.
Compare that to APR, where the interest rate on a loan is a simple amount that you pay monthly.
If interest is being earned or paid, there’s a corresponding APR and APY. Something to watch out for is that financial institutions often advertise credit products using APR, which may seem like a small number. However, APR fees most often add up to thousands of dollars in fees each year.
Frequently Asked Questions
What does APR mean?
APR stands for annual percentage rate and is the yearly interest rate you pay on a loan. Understanding how APR works is important because it can give you a good idea of how much you’ll pay to take out a loan. You can then make the call whether or not it’s worth it to you to pay that amount in fees.
What is a good APR?
It depends on the type of loan or credit product. Generally speaking, borrowers with a good credit score are going to qualify for the best APR rates.
At the time of this writing, the average credit card APR is around 20%. If your rate is lower than that, some might consider it good. But remember that this is still an interest rate you are paying. At the end of the day, the best APR is zero because you will not be in debt.
What is a bad APR?
Any APR over 20% could be considered bad. If you are stuck in credit card debt and are paying high APR fees, look for balance transfer opportunities with 0% introductory APR periods.
What does zero APR mean?
A 0% APR means that you pay no interest fees on certain transactions during a certain period of time. For example, if you sign up for a new credit card that offers a 0% promotional APR for both qualifying purchases and balance transfers, you won’t have to pay any interest during this promotional period.
0% APR Key Takeaways:
- You will pay no interest on your purchases or balance transfers for a promotional period, which generally lasts from 2 to 21 months, depending on the card.
- Promotional 0% APR offers can make debt cheaper to pay off, which helps you get out of debt faster.
- A 0% APR does not free you from the requirements of making monthly payments.
You must pay at least your monthly minimum to avoid being categorized as late. Late payments damage your credit score and can cause the lender to terminate the 0% introductory rate.
- After the promotion term, you may be looking at a high regular APR. So you should aim to bring your balance to zero by the end of the 0% APR period.
Make The Best of Low APRs
Now that you know more about annual percentage rate, you can be on the lookout for introductory offers that might help you pay off debt faster.
You should also try to avoid paying high fees because they can quickly add up, and make it difficult for you to get out of debt.
Understanding these basic things should help you make better decisions about managing your money. Good luck!