What Is an Annual Percentage Rate (APR)?
The term “annual percentage rate (APR)” refers to the annual rate of interest charged to borrowers and paid to investors. APR is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan or income earned on an investment. This includes any fees or additional costs associated with the transaction, but does not include compounding. The APR provides consumers with a single number that they can easily compare to rates from other lenders.
You’ve probably heard of the term APR, or annual percentage rate applied to everything from mortgages to auto loans to credit cards. In this article, we’ll look at credit card APRs, which you’ve most likely seen listed on your monthly statements. Understanding what an APR is, how it’s calculated, and how it’s applied can help you make better credit card decisions.
How Annual Percentage Rate (APR) Works?
An interest rate is defined as an annual percentage rate. It calculates what percentage of the principal you’ll pay each year by taking into account factors such as monthly payments. APR is also the annual rate of interest paid on investments that doesn’t account for interest compounding within that year.
Types of APR
It’s also important to understand the APR on your loan. You’ll either have a fixed or variable APR in most cases.
1.Fixed APR
A fixed APR means the APR doesn’t change based on an index during the period of the loan. Because of this, fixed APRs can be more predictable when it comes to budgeting. Common examples of loans with fixed APRs include most personal loans and mortgages.
2.Variable APR
Variable APRs are tied to an index interest rate, such as the prime rate reported in the Wall Street Journal, and can fluctuate. As a result, if the prime rates increase, so does the variable APR. So if the prime rate increases, so would a variable APR.
3.Cash Advance APR
Borrowing cash with your credit card usually has a higher interest rate. APRs for checks and cash advances may differ. And there is usually no grace period with these transactions.
4.Penalty APR
If you violate the terms of your card’s contract, such as missing or being late with a payment, the APR on your card may rise for a period of time. Check your card’s terms and any notices your issuer sends you about your account.
5.Introductory APR
A new credit card may come with a lower, limited-time APR. It can apply to purchases or specific transactions such as a balance transfer.
How Is Annual Percentage Rate (APR) Calculated?
The rate is calculated by multiplying the periodic interest rate by the number of periods in a year that the periodic rate is applied. It is not specified how many times the rate is applied to the balance.
APR=(((Fees+Interest Principle)/n)×365)×100
where:
Interest=Total interest paid over life of the loan
Principal=Loan amount
n=Number of days in loan term
In the United States, annual percentage rate (APR) is typically expressed as the periodic interest rate multiplied by the number of compounding periods per year. APR definitions outside of the United States may differ significantly. In defining this term, the European Union (EU) focuses on consumer rights and financial transparency. A single interest rate calculation formula has been established for all EU member nations, though individual countries have some leeway in determining the exact situations in which this formula is to be used above and beyond EU-specified cases.
Annual Percentage Rate (APR) Example
Let’s say you take out a $1,000 loan. And over a 150-day loan term, you’ll end up paying $75 in interest and a $25 origination fee to take out the loan.
Let’s do the math to calculate your APR.
First, add the origination fee and total interest paid.
$75 + $25 = $100
Then, take that number and divide it by the loan amount.
$100 / $1,000 = 0.1
Next, divide the result by the term of the loan.
0.1 / 150 = 0.00066667
Then, multiply that result by 365.
0.00066667 x 365 = 0.2433333
Finally, multiply that by 100 to get the APR.
0.2433333 x 100 = 24.33%
APR vs. Interest Rate
Some people mistakenly believe that interest rates and annual percentage rates are similar. Although this is usually true for credit cards, when it comes to loans, the terms have different meanings. Recognizing the differences between the interest rate and the APR can help you appreciate the cost of a loan if you’re thinking about taking one out.
An interest rate is a percentage of the loan principal that a lender charges you to borrow money. So, what exactly is APR? Instead of just the interest rate, APR can also include any fees you may be required to pay in order to obtain the loan. As a result, APR provides a better estimate of the total cost of the loan as a percentage.
APR vs. Annual Percentage Yield (APY)
While an APR only considers simple interest, the annual percentage yield (APY) considers compound interest as well. As a result, the APY of a loan is higher than its APR. The greater the difference between APR and APY, the higher the interest rate and, to a lesser extent, the smaller the compounding periods.
Assume that the APR on a loan is 12% and that the loan compounds once a month. If an individual borrows $10,000, the interest for one month is 1% of the balance, or $100. This effectively brings the balance up to $10,100. The following month, 1% interest is applied to this amount, and the interest payment is $101, which is slightly higher than the previous month. If you carry that balance over for the entire year, your effective interest rate rises to 12.68%. APR does not account for these minor changes in interest expenses caused by compounding, whereas APY does.
Here’s another way to look at it. Assume you’re comparing a 5% per year investment with a 5% per month investment. For the first, the APY equals 5%, which is the same as the APR. However, the APY for the second is 5.12%, reflecting monthly compounding.
Bottom line
Knowing what APR is can be especially useful when making a big purchase or applying for a credit card.
This information can help you make more informed decisions, especially when comparing multiple loan options. While a lower interest rate may be appealing, the APR on the loan can give you a better idea of how much you’ll pay for the loan overall.
