This is how the annual percentage rate works

If you’ve researched new credit cards or are considering refinancing your home loan, you’ve probably noticed that the term APR is popping up everywhere. APR stands for the annual percentage rate, and in terms of necessary financial information, understanding the APR is pretty high on our list.

In this article, we’ll go over the basics of APR – what it is, how to calculate it, and how to improve it – so you can be an informed borrower.

What is the APR?

APR stands for Annual Percentage Rate. It represents the annual interest and associated costs of a loan including loan-specific fees such as loan origination fees or mortgage insurance. You’ll find the APR listed for credit cards, auto loans, mortgages, personal loans, and most other lines of credit. In fact, lenders are required to disclose the APR of a loan to the borrower through the Truth in Lending Act (TILA).

Because the APR takes into account some of the costs of a loan, the APR is often a more accurate representation of the cost of borrowing than the interest rate alone.

For example, one mortgage might boast a low interest rate through discount points but higher fees, while another might have a higher advertised interest rate but lower fees. Interest rates alone can be misleading. Therefore, reviewing the APR will allow you to more accurately compare the overall cost of these two loans.

Essentially, the higher the APR, the higher the cost of borrowing and vice versa. While not all fees are included, the APR is a good starting point for comparing lines of credit.

The two types of APR

There are two types of APR: the fixed APR and the variable APR.

As it looks, the fixed APRs don’t change. The rate you locked in at the start of the loan remains in effect for the life of the loan. As a result, fixed APRs are more predictable than a variable APR. The actual rate offered to you depends on market conditions (and your credit rating) at the time of loan / request.

Although this rate may change, the lender is required by the Consumer Financial Protection Bureau (CFPB) to notify you in writing.

Variable APRs are tied to an index interest rate, such as the Wall Street Journal Prime Rate. This underlying rate fluctuates with economic conditions and therefore the varying APRs fluctuate as well. Basically, when the indexation rate goes up, your variable APR goes up.

Most credit cards use variable APRs, and although you can find directions in the cardholder’s agreement as to when the APR may change, the lender is not required to notify you of the rate change.

Credit cards also often have multiple APRs depending on the type of transaction. These different transactions also have different grace periods, a period between the account closing date and your due date where you can pay for your purchases without penalty (aka interest).

APR terms you need to know

There is more to our understanding Credit card 101, but see the glossary below for a quick overview of how typical different transactional APRs work.

Each card will offer slightly different terms for each of them, so it’s important to check the cardholder’s agreement when considering a new credit card.

Purchase APR

The purchase APR is the interest rate applied to purchases made with the credit card. If you pay your statement in full each pay period, you’ll avoid all of this together. Most credit cards have a grace period between the end of the billing period and the date your payment is due. During this period, you can repay the purchase without incurring interest. If you hold charges on the billing cycle, the purchase APR is applied accordingly.

Balance transfer APR

APR Balance Transfer is the interest rate charged when you transfer a balance to your credit card. Some cards offer low promotional balance transfer rates. Just be aware that once the promotion ends, you will be charged the Regular Balance Transfer APR on the remaining balance.

APR cash advance

Cash Advance APR is the interest rate charged for the privilege of borrowing money from your credit card. Normally, this APR is greater than the purchase APR and there is no grace period.

APR penalty

The APR penalty is the interest rate charged when you violate the terms of the cards, such as making a late payment. Not all cards have a penalty APR, but if it does, it is normally the highest APR.

Introductory APR

Introductory APRs are normally very low rates that apply for a set period of time. Just make sure you know the schedule and APR after the promotional period ends.

The difference between APR and APY

APR (Annual Percentage Rate) and APY (Annual Percentage Return) are easily confused. Knowing the differences can pay you big financial dividends and save you unexpected financial costs.

APR and APY are ways to demonstrate interest rates. As we have seen, the APR is the annual percentage rate and demonstrates the combined annual cost of interest and charges on a loan. APY is the annual percentage return and similarly combines interest and charges, but also takes into account the effects of compound interest.

If you pay off your interest on your loan or credit card balance each billing period, your APR will be an accurate representation of your costs. However, if you keep a balance it will cost more than the APR as you will now be paying interest on the interest you were charged i.e. compound interest. This is where the APY, which already includes compound interest, comes in handy.

For this reason, a credit card issuer or bank often chooses APR or APY to represent their product. For example, a credit card will most often advertise the APR because the rate is lower and does not show the effects of compound interest; it may seem cheaper. Again, this is not a misrepresentation, just a strategic representation. On the flip side, a savings account that earns you interest will often offer you the APY because it focuses on growing your money.

The important thing to know is that just because you see the APR doesn’t mean that you are exempt from the effects of compound interest.

How to calculate the cost of the APR for you?

It’s important to understand how much a loan will actually cost you or your outstanding credit card balance. Each bank has different margins and interest rates, but the whole concept is the same.

For example, suppose you have a balance of $ 700 on your credit card with an APR of 25.99%. Since the APR is an annual rate, you first need to find your daily interest rate by dividing the APR by 365 days.

25.99% ➗ 365 days = 0.0712%

This means that each day that a balance is carried over, you are charged 0.0712%, which for $ 700 equates to about 50 cents per day. Although it seems low, interest is quickly starting to grow. If the card bill is assessed monthly, take this rate and multiply it by the number of days in the month.

.0712% ✖ 31 days = 2.21%

Multiply that new monthly rate by the $ 700 balance carried forward and maintaining that balance will cost around $ 15.45 this month.

Before opening a new line of credit, it’s worth doing a few simple calculations like this to understand the cost of that credit.

What determines the APR that is offered to you?

APR calculations often start with an index rate that reflects current economic conditions. Credit cards then add fees to those called margin for using their service. This margin is highly dependent on the credit rating of the card holder. People with good credit scores are offered better APRs than those with poor credit scores. For this reason, it is important to understand how improve your credit score. There are many ways to increase your score, but here is a list of the simplest and most common:

  1. Establish credit

  2. Pay your bills on time

  3. Keep your existing card balances low

Over time, these small changes can improve your credit score and lower your overall cost of borrowing.

The bottom line

Credit and loans are a part of modern life, so APR is not going anywhere. While you might be the type of borrower who pays your credit bill in full every month, there may be times in your life when you can’t completely avoid paying interest. In these times, understanding the APR will help you be a smart borrower.

And as you make those decisions, here are the key takeaways:

  • The APR represents the cost of borrowing credit, including interest and charges.

  • Fixed APRs have a fixed interest rate for the term of the loan, while the variable APR rate is subject to change without notice.

  • APY is different from APR in that it takes compound interest in its calculations.

  • Improving your credit score can help you achieve a lower and therefore better APR.

Frequently Asked Questions (FAQ) about APR

If you’re still thinking about APR, keep reading to see our answers to some of the most frequently asked questions.

What is PRA in simple terms?

Basically, the APR (Annual Percentage Rate) is the amount it will cost you each year to borrow money. It is expressed as a percentage and includes the interest rate and the fees that you will have to pay to use the loan.

Is 17% a good APR for a credit card?

A good APR is lower than the current average interest rate. Currently, the average APR is 14.68%, but credit card companies only offer it to people with good credit scores. Therefore, although 17% is higher than the average credit APR, it is still less than many marketed credit cards, so based on your credit score this is a decent option.

What is an APR of 24%?

An APR of 24% means that is the interest rate that you will be charged during the year for the money borrowing service. This means that if you hold an outstanding balance of $ 750 for a year with an APR of 24%, you will pay around $ 180 in interest. However, the APR does not take into account compound interest, so this cost may be higher if you accumulate interest during the year.

What does 30% APR mean?

30% APR is the amount of money you will pay to borrow money from a lender. While the APR represents an annual rate, interest is often applied monthly or daily. A 30% APR works out to a daily interest rate of 0.082% or a monthly interest rate of 2.5%.

Contributor Whitney Hansen writes for The Penny Hoarder on topics related to personal finance, including banking and investing. Writer Sarah Kutra contributed to this report.

This was originally posted on The Penny Hoarder, which helps millions of readers around the world earn and save money by sharing unique job opportunities, personal stories, giveaways and more. The Inc. 5000 ranked The Penny Hoarder as the fastest growing private media company in the United States in 2017.

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