You may have come across APR when exploring different options for credit or loans, but what does it mean and how does it work? Here we look at what APR is, how it is calculated, and how it works.
What is APR?
Annual percentage rate (APR) is the yearly interest charged on loans. It is generated by a sum that is paid to investors or charged to borrowers. APR, as the name may suggest, is expressed annually; it is shown as a percentage representing the actual annual cost of funds over the loan term or income earned on an investment. The APR will also include any additional fees or costs associated with the transaction. APR allows consumers to compare and contrast different lenders, forms of credit or investment products.
You will typically find APR talked about in relation to credit cards, mortgages and loans. In fact, under federal consumer law, it is required that lenders must disclose APRs up front. All of this helps the consumer to make smarter decisions about their loans and credit.
Key Points
- APR stands for Annual Percentage Rate
- It works as an annual interest rate, calculating the percentage of the principal that would be paid over the year
- Even for short-term loans, an APR is used to express interest rates
How Does APR Work?
APR works as an annual interest rate. This means that it calculates the percentage of the principal that you would pay each year by taking into account things such as monthly payments.
Lenders must disclose the APR charged to borrowers before entering any loan agreements. Credit cards, on the other hand, are allowed to advertise interest rates on a monthly basis; however, they will need to report the APR to customers before they actually sign any agreements.
Generally speaking for credit cards, you will only pay the APR if you carry a balance on your card. That is to say, if you only make purchases on your credit card and pay off your balance each month on the due date, it is unlikely that you will accrue any interest; you will simply pay off what you have spent.
How is APR Calculated?
Credit card APRs can vary between companies, but the majority of them use the U.S. Prime Rate; this is the interest rate which financial institutions charge when lending money to their customers. On top of this, lenders are able to add a small fee on top (a margin) in order to get the final figure of the APR. The margin will vary from lender to lender depending on the type of card, the customer’s credit score and the purpose of the card.
The prime rate itself is not a stable figure; it can fluctuate based on the wider economic landscape. Fixed-rate credit cards will hold a stable APR, even if the prime fluctuates.
APR is calculated by multiplying the loan term interest rate (periodic interest rate) by the number of periods in a year which it was applied.
For loans, APR is calculated by working out how much the loan is going to cost you annually based on the interest rate and finance charges. displayed as a percentage, it can help you understand the cost of borrowing and help you compare between different loan products and lenders.
Something to be aware of is that payday loans often carry extremely high interest rates at 400% or 600% but this is because the rates are multiplied as if they last an entire year, whereas they may only last a few weeks.
APR is calculated as an annual percentage rate, even if it is a short-term loan of just two weeks.
What Types of APR Are There?
For different financial products, there are different types of APR.
Credit card APRs, for example, will be based on the type of charge. This means that there may be one APR associated for purchases, but another APR entirely for cash advances or balance transfers between cards. In general, credit card companies charge high-rate penalty APRs if customers meet payments too late or are in violation of the cardholder agreement in any way. Most companies will offer an introductory APR (which is usually 0% or very low) and is used to encourage new customers to sign up.
Within credit cards, there are different APRs depending on how you are using the card. Before taking out a credit card, first assess the APR rates and also what you will be using your credit for.
Purchase – the rate applied to credit card purchases
Cash advance – this is the rate applied if you borrow money from your credit card
Penalty – the rate applied to balances if you violate the cardholder agreement (e.g. late payments), This is usually the highest APR.
Introductory / promotional – a low APR rate that is typically offered at the start of a cardholder agreement and for a limited time only. It could apply to specific transactions, balance transfers, cash advances, or a combination.
Bank loans will use either fixed or variable APRs which will impact how much the APR will fluctuate and change over the duration of the loan term. A fixed APR loan comes with an interest rate that is guaranteed to stay stable. Variable APR loans, on the other hand, have interest rates that can change at any time.
The amount of APR that borrowers will be charged will also depend on their personal circumstances, namely their credit history. For borrowers with excellent credit, their APR will be substantially lower than borrowers with bad credit.
