What is APR?
APR is the annual percentage rate of a loan. In other words, it’s the yearly cost of an interest rate or what the lender charges you to borrow money on an annual basis. This percentage is averaged over the full duration of a loan and is a representation of your interest rate.
Understanding APR helps you make better choices when it comes to borrowing money, using credit cards and improving your credit score.
How does APR work
APR works by first having lenders assess how risky it is to loan you money. Then, they quote you an APR based on your risk level. These lenders perceive low-risk borrowers as those with good credit history and low debt utilization. A person with these financial qualities may be rewarded with a lower APR than someone with poor credit history or significant debt.
In general, lenders determine your APR based on a number of factors, including:
- The type of loan you apply for
- Your current debt
- Your credit history and current score
Consider this example: $1,000 is borrowed on a credit card. If the credit card has an APR of 11 percent, at the end of one year $110 will have been accumulated, raising the total cost of the loan to $1,110.
Depending on the situation, the way APR affects your total loan may vary. For example, if you pay your credit card balance in full each month, you may avoid interest completely and APR will have no effect on how much the credit card lender charges you to use their money.
On the other hand, leaving a balance on your credit card for an extended period of time may rack up interest and as a result, APR will have more of an effect on how much you owe.
How to calculate APR
To calculate APR, you can follow these 5 simple steps:
- Add total interest paid over the duration of the loan to any additional fees.
- Divide by the amount of the loan.
- Divide by the total number of days in the loan term.
- Multiply by 365 to find annual rate.
- Multiply by 100 to convert annual rate into a percentage.
This formula does not account for compounding interest rates and shows the total cost of the loan for only one year. APR can be calculated by hand, using spreadsheet software or an online calculator. Note that numbers may vary based on how you calculate APR.
When determining APR, keep these things in mind:
- Interest rate
- Loan amount
- Duration of loan
- Additional fees
How to Calculate APR Using a Spreadsheet
Calculating APR using a spreadsheet is a simple way to find costs. Imagine you take out a $30,000 loan at 6.5 percent interest for five years. You will also be expected to pay a $600 closing fee.
Follow these steps to calculate APR for this example using a spreadsheet.
Step 1: Calculate the monthly payment on the loan.
Use this spreadsheet formula to find the monthly payment on the loan:
- =PMT(interest rate/months, total number of months, loan value + fees)
Using the numbers from the example, find monthly payment:
- =PMT(0.065/12, 60, 30600)
Monthly payments for this loan equal $598.72.
Step 2: Find the monthly rate.
Use a new formula to calculate APR:
- =RATE(total months, monthly payment as a negative, current loan value)
Find monthly rate by plugging in the correct numbers:
- =RATE(60, -$598.72, 30000)
Monthly rate equals 0.611 percent.
Step 3: Calculate APR using the monthly rate.
Multiply the monthly rate by 12 to get an annual percentage rate:
- 0.611 * 12 = 0.0733, so APR equals 7.33%.
The difference between APR and interest rate
APR and interest rate are similar but act in different ways.
APR is the annual calculation of interest that takes into account any fees or charges you may incur during the life of the loan.
On the other hand, interest rate is the current calculation of the cost of a loan. It does not take into account additional fees and only accounts for the interest accrued by the loan. For this reason, the APR may be higher than the interest rate.
Most borrowers know that being selective with interest rates is important. However, being mindful of APR may give you a better idea of the big picture cost for a loan.
The difference between a variable APR and a fixed APR
Just like interest rates, APR can fluctuate with changes to an index. This is called a variable APR and generally follows an index like the U.S. Prime Rate published in the Wall Street Journal and set by the Federal Reserve. Most credit cards today function on variable APR and have fluctuating rates based on the movements of the prime rate.
Conversely, a fixed APR does not follow an index. This doesn’t mean it won’t change –– a missed payment or change in market may cause a change to the APR, but the lender must notify you before the change occurs.
Types of APRs on credit cards
There are five types of APRs found on most credit cards. Depending on the card issuer, any of these types may be used. You may even see more than one type during the lifetime of your credit card.
- Purchase APR: This APR is the most common and affects new purchases that are not repaid in full before the end of the grace period.
- Balance Transfer APR: This rate applies to any funds transferred from one card to another. It is charged from the date of the transfer with no grace period.
- Introductory APR: Commonly used with auto loans and credit cards, this low APR allows card carriers to hold a balance without incurring interest for a certain amount of time. You may have a 0 percent introductory APR for 12 months that will then become a balance transfer and purchase APR after the 12-month period.
- Cash Advance APR: This APR results from a cash withdrawal from your line of credit. The rate may be slightly higher to account for risk and is best used when the funds can be quickly repaid.
- Penalty APR: Late or missed credit card payments will cause a penalty APR, which may apply indefinitely to your account based on your cardholder agreement. To avoid this APR, autopay is helpful for staying on top of payments.
When considering APR, making payments on time and repaying balances in full can significantly impact the way rates affect your loan. Setting up autopay and creating payment reminders can help you stay on top of payments.
Remember, APR is determined using your credit history and score, among other factors. If you apply for a loan, credit card or mortgage and are concerned about your credit health, be sure to check the terms and conditions, cardholder agreements and other contracts for information about applying with poor credit.