Simply, APR is the total rate of interest you will pay annually over the life of a loan. This plays an important role in many consumer financial products, such as credit cards, auto loans and mortgage loans. Continue reading to learn more about APR.
What Is APR and How Does It Work?
APR stands for annual percentage rate and it represents how much it costs to borrow money. APR is based on the interest rate and all fees charged by the lender. It is expressed as a percentage.
A loan issuer, normally a bank, is responsible for setting an APR. Generally this rate is determined by the U.S. prime rate, which is the best rate that lenders offer their most reliable customers. Bank will then charge a margin of profit on top of the prime rate. The higher your credit score, the lower the APR you will get.
For credit cards, banks use either a daily or a monthly periodic rate. They figure this out by dividing the APR by 365, this gives you the daily periodic rate. Dividing the APR by 12 gives you the monthly periodic rate. The lender then adds the periodic accrual to your balance.
What Is the Difference Between APRs and Interest Rates?
APRs and interest rates are related but have slightly different calculations. The interest rate refers to the amount of money the lender charges you for the loan. APR factors in the total cost of the loan.
Although most loans may not have additional fees and charges, they may come with origination fees, monthly maintenance fees or check processing fees. Factoring in these fees increases the total cost of borrowing money.
If you’re wondering how to calculate an APR for a credit card, let’s use this scenario. When you take a cash advance of $1,000 on a credit card, for example, the card issuer might charge an interest rate of 20%. If the card issuer also charges a cash advance fee of 2%, the APR — the actual cost of borrowing the money — is 22%. If there are not other fees associated with borrowing money, then there’s no difference between the interest rate and APR. A lot of the time, APR is higher than the stated interest rate of an account.
Difference Between Types of APRs
When you take a look at your credit card disclosure statement, you might notice one APR listed. However, there are different types of APRs, even for the same account. Here is a quick look at them:
- Purchase APR: Applied to purchases you make with the credit card. You pay this APR if you don’t pay the balance within the grace period.
- Cash advance APR: Applied when you withdraw cash using the credit card. This tends to be higher than the purchase APR.
- Penalty APR: The highest APR. It applies to certain balances when you do something like miss a payment or exceed your credit limit.
- Introductory APR: Often the lowest APR. It’s typically used as a promotion, such as a temporary 0% APR for balance transfers.
What Is a Good APR
APR is only one factor to consider when choosing the right credit card or loan for you. It is important to keep your options open and compare all the terms of each product you’re looking at. These features are important:
- Annual fee
- Cash advance fee
- Finance charges
- Grace period
- Late payment fee
- Rewards program
- Security features
A good APR can be hard to come by but it is defined by having a lower than average interest rate. These APRs are usually reserved for customers with the highest credit scores. Also, when deciding on the right credit card or loan for you, there are other factors to look at besides the APR. For more posts like this, check out our list of bank guides!