What is APR?

Quick insights

• Annual Percentage Rate (APR) is an important metric used by financial institutions to calculate the cost of borrowing money and additional fees associated with the transaction.
• To potentially save money in the long term, you may want to compare APRs across different lenders. After you demonstrate creditworthiness, you may want to call and attempt to negotiate for a lower interest rate.
• When you apply for a loan or credit card, there are two types of APR: Fixed APR and Variable APR. Both interest rate options have benefits and drawbacks.

You may have heard of APR but are not entirely sure what it means. APR stands for Annual Percentage Rate and it represents the annual cost of borrowing money. APR is the yearly interest rate charged to consumers and businesses for borrowing money from loan providers. APR provides a more accurate measure of the full cost of borrowing on an annual basis, including fees.

The importance of APR

APR was first introduced to the banking industry in 1968 via the Truth in Lending Act, also known as TILA. This legislation was created to promote more transparency and clarity by requiring loan providers to disclose terms and the true costs of consumer credit. The formula widely used to calculate APR is below.

Annual Percentage Rate = [(Interest charges + fees) / Principal / n x 365] x 100

*n = number of days in the loan term

The formula remains the same regardless of the financial institution. However, the fees will vary based on the lender, type of loan, duration of the loan and current market conditions. It’s important to know the APR, so you can compare different loan products. Consumers who have a credit card or loan account and strong track record of making payments on time can contact their card issuer and potentially negotiate a lower APR. Your APR is conveniently located on your monthly credit card or loan account statement.

How APR affects your credit and personal finances

APR can have an impact on your personal finances and the different types of financial accounts you have. Knowing the APR on your credit card can be essential. The higher the interest rate, the more you pay when you carry a balance. The lower the interest rate, the less money you may have to pay in the long run.

To potentially avoid a purchase APR, you may want to consider making consistent monthly payments on-time and paying off the balance in full each month. Purchase APR is the amount of interest you pay on purchases made with your credit card when you don’t pay your balance in full by the due date.

It can be important to shop around, read the fine print and use trusted tools to calculate your estimated loan and interest payments. APR helps you understand the full picture of borrowing money and how it can impact your overall finances.

• For example, you decide to take out a $20,000 car loan at 5% APR with a term of five years. Your total cost, excluding fees and taxes, will be $22,645.48 which represents the original loan of $20,000 and $2,645.48 in interest. If the APR is 5.5%, the total cost of the auto loan will be $22,921.39 which represents the original loan of $20,000 and $2,921.39 in interest.

APR and balance transfers

A balance transfer is when you move outstanding debt from one credit card or loan to another. In this context, APR would be the interest rate you will pay on the balance you transfer from the other card to a new credit card or loan.

This can be a great option for consumers to possibly secure a lower promotional interest rate. For instance, moving your debt to a credit card with a low introductory APR offer on balance transfers can be a strategic move to help you pay off debt during the introductory period. Keep in mind there will be a balance transfer fee, which typically costs between 3%-5% of the transfer amount.

Types of APR

There are two interest rate options when applying for credit or loans: Fixed APR and Variable APR. Both interest rate options are typically used when applying for installment loans such as mortgages, auto loans and personal loans. Fixed APR and Variable APR are also used when applying for revolving credit such as credit cards, personal lines of credit and home equity lines of credit.

Fixed APR: The interest rate remains the same over the life of the loan.

• One potential pro of selecting fixed APR is the level of certainty it can provide over the long haul. This can make creating a budget easier because the rate is consistent month to month.
• One potential drawback is when the Federal Reserve decreases interest rates. When the Federal Reserve cuts rates, fixed APR stays the same, while variable APR can decrease.

There are certain circumstances where fixed APR can increase. Examples include:

• When you consistently miss payments and a penalty APR is applied
• When you carry a high credit card balance
• When a low-interest promotional period ends
• When you take out a cash advance

Variable APR: The interest rate fluctuates based on market conditions and current prime rates.

• One potential pro to selecting Variable APR is that when interest rates fall, your APR also has the potential to fall, which can result in lower payments.
• One drawback is when the Federal Reserve increases interest rates, your APR can increase, which can result in higher monthly payments.

APR vs. APY

Although APR and APY both start with an “A” and contain three letters, they are very different when it comes to meaning.

• APR stands for Annual Percentage Rate which represents the annual interest rate charged for borrowing money, but it does not include compounding interest. Most credit card companies will compound interest daily meaning you end up paying interest on the principal amount plus interest on the interest that accrued from the previous month.
• APY stands for Annual Percentage Yield and represents the amount of interest earned in a calendar year and this is often found on bank accounts. Compound interest, in this instance, is when interest is earned on the sum of your banking account balance plus any accumulated interest earned.

With APY, you earn money simply by saving a particular amount in a financial account. Many banks pay an APY on checking, savings, money market accounts and more.

In conclusion

APR gives you a holistic view of the total cost of a loan. It can impact your finances in both the short and long term. When shopping with lenders and credit card providers, it can be beneficial to focus on the APR to help you determine the full impact a potential loan or credit card can have on your budget. Compare multiple loan providers and select the best option for your financial situation.