What You Need To Know About Annual Percentage Rates
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Most people who have ever tried to buy a car or open a credit card account have heard the terms APR (annual percentage rate) and interest rates, but not many people could easily explain the difference between the two. In fact, many people might assume that the terms are roughly interchangeable, but that's not actually the case. Knowing the APR on a loan will generally give you a more accurate idea of the total cost of borrowing than knowing the interest rate alone. This article will go into a little more detail about the difference between annual percentage rates and interest rates, how APR is calculated, and some of the different types of APRs you might encounter.
Written by Attorney Aan Malahia Chaudhry.
Updated November 30, 2021
APR stands for annual percentage rate. It describes how much a loan will cost or how much an investment will earn. In this article, we're dealing primarily with loan costs and not investment earnings. Interest rates and APRs are both calculated as an interest percentage, but the two are not the same. It’s important to know the difference so you’ll know what your total costs are when you borrow money.
How Is an APR Different From an Interest Rate?
Consumers can use both APRs and interest rates to comparison shop for loans. In general, a loan or line of credit with a lower interest rate or APR is more affordable than one with a higher rate. A more affordable loan will have smaller monthly payments, and you’ll also pay less over the life of the loan.
When you take out a loan, you have to pay back the principal amount you borrowed plus the interest that accumulates on the principal. The accumulating interest is computed using your interest rate and how much money you owe on the loan. So the interest rate is the annual cost you’ll pay on the principal of the loan. It doesn’t account for fees or other costs of borrowing.
When you take out certain loans, your initial monthly payments will contribute more to the interest than the principal. As your principal amount goes down, a lower proportion of your monthly payment will go toward interest. This process is referred to as mortgage amortization. Mortgages, personal loans, student loans, and auto loans are examples of loans that amortize.
Interest rates can be fixed or variable. Fixed rates stay the same throughout the loan period. Variable rates change according to the market rates.
By contrast, APR is a broader term that helps you see the annual cost of the loan. It includes the interest rate, but also many other fees and expenses associated with a loan. So the APR gives you a better idea of the total cost of borrowing. For example, an APR for a mortgage will include mortgage insurance, closing costs, discount points, and loan origination fees. Not all lenders calculate APR the same way. Some lenders may include or exclude different charges. This can make it difficult to compare if you’re shopping around for home loans. When you're comparing APRs, it's important to see which fees are included in the APR for each loan to make a fair comparison.
Annual Percentage Yield (APY)
APR is used to calculate the cost of a loan with simple interest. APY is used to calculate the cost of a loan with compound interest. Simple interest is computed on the principal amount only. Compound interest is computed on the principal and any additional interest you’ve accrued so far. As a result, APY rates are higher than APRs. Generally, financial institutions will use APRs in discussing loans. But many online calculators provide an estimate of your APY based on your saving and payment frequencies.
How Is the APR or Interest Rate Determined?
Interest rates are determined by two main factors: market rates and the borrower’s credit score. Market trends and prevailing rates influence current interest rates. Other than shopping around for the best rate, these factors are generally outside your control as a borrower. You do have some control over your credit score, which is also an important factor. Your credit score tells the lender how likely you are to repay the loan and how risky it is to lend to you based on your past borrowing behavior. Borrowers with higher credit scores typically get lower interest rates because they are less risky to lend to.
APR is determined largely by the lender since it’s calculated using the interest rate as well as lender fees and other costs that vary by lender. While it’s important to look at the overall cost of a loan, most borrowers will also want to know what their monthly payment will be. This is based on the interest rate and principal balance, not the APR.
By law, lenders are required to disclose the APR in every consumer loan agreement, so it shouldn’t be difficult to find. The Truth in Lending Act (TILA) is the federal law that requires this disclosure. TILA helps prevent lenders from misleading borrowers, and it provides borrowers with a complete picture of the cost of borrowing. This allows borrowers to confidently compare different interest rates and other fees associated with borrowing.
How APR Is Calculated
It's good to know how your APR is calculated and what components go into it. If your algebra is rusty, don’t worry, as there are many free online calculators that can help you calculate your APR. Your APR is calculated based on: your loan amount (principal), interest rate, fees, and the number of years you have to repay the loan (term).
You can calculate your APR in the following five steps:
Take your total interest paid over the life of the loan and add any additional fees.
Divide that amount by your principal.
Divide that by the number of days in your loan term.
Multiply by 365. This will give you your annual rate.
Multiply your annual rate by 100. This will give you the APR as a percentage
Combined the steps look like this: APR = ((((Fees + Interest) ÷ Principal) ÷ n) x 365) x 100.
Credit Card APRs
You may have seen credit card companies highlighting a promotional APR. APRs in the context of credit cards describe the interest that's applied in a billing cycle. Credit card issuers can offer variable and non-variable APRs. A fixed APR doesn’t fluctuate with the index interest rate. An index interest rate is a benchmark used by financial institutions to determine the interest rate of loans and other financial products. Fixed APRs can be changed by the credit providers, but the cardholder must be notified. A variable rate, on the other hand, fluctuates with the index interest rate.
Many variable interest rates start by using an index, such as the U.S. Prime Rate, and then add a margin to come up with their APR. An example of the rate calculation looks like this: APR = U.S. Prime Rate (as published in Wall Street Journal) + margin that the bank charges.
To calculate the amount of interest you're charged in a month, you need to know your APR, billing cycle, and balance. Your bank statement will generally provide information on how to determine your balance. Once you have these figures, you can calculate your interest in two steps using the following equations:
APR ÷  days in a year = Daily Periodic Rate (DPR)
(DPR x days in billing period) x Balance subject to interest rate = interest charged
The greater the balance, the more interest you're charged. Paying off your credit card debt before the due date and shopping for lower APR rates can reduce the amount of interest you pay.
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Types of APR
A credit product may have several different APRs for different types of transactions. For example, credit cards can have:
Purchase APR: This is the rate applied to credit card purchases. Most credit card companies provide a grace period on purchases, but this isn’t required by law.
Cash Advance APR: If you're borrowing cash from your credit card, the interest rate will generally be higher than the interest on purchases. Different advances may have their own APRs, but cash advances don’t usually have grace periods. This means that interest is charged from the day the advance is made.
Penalty APR: If you violate the card terms and conditions, such as by failing to make payments, you may be subject to a penalty APR. This will depend on your card issuer and the terms of your credit card. This is usually the highest APR.
Introductory APR (also called promotional APR): This is an APR that is reduced for a limited time, often for a number of months when you first get a new credit card. It can apply to specific transactions, including balance transfers, cash advances, or any combination.
Annual Percentage Rate Shortcomings
APRs are a good way to estimate the total cost of borrowing and to compare similar loan products. But they aren’t always an accurate indicator of these costs and may underestimate actual costs. For instance, mortgage lenders may calculate APRs that exclude certain charges such as appraisals, titles, credit reports, applications, document preparation, and other fees.
Additionally, APR calculations assume that all the fees will be spread out over a long period. For instance, the APR for the loan assumes that the closing costs are spread out over the terms of the loan, usually a 30-year term. But if you only live in the house for a few years, the annual impact of those costs will be more significant as they will be spread out over a shorter time frame.
Another weakness is that APR estimates always assume a fixed interest rate.But if you have an adjustable-rate mortgage, your interest rates may change. When the interest rate increases, so does the APR. So the APR may underestimate the actual borrowing costs. It is very difficult to predict what the interest rates will be in the future.
The interest rate is the annual cost on the principal of a loan. It’s also what’s used to calculate your monthly payments. The APR is a broader measure that includes the annual cost of the interest as well as other fees or costs. For investments, APR tells you how much an investment will earn you.
By law, lenders must tell you what the APR is for financial products like loans before you can sign an agreement. This helps protect consumers from misleading advertising and makes it easier for them to compare loans. That said, APRs don’t always reflect the actual cost of borrowing because lenders may not include every fee when they calculate their APR. APR only accounts for simple interest. Compound interest is accounted for in APY. It’s important to know the difference between these rates to determine the total cost of borrowing.