What is the Annual Percentage Rate?
Annual percentage rates come into play when borrowers seek mortgages or credit cards. The annual percentage rate, or APR, is the amount of interest you’ll pay annually on your loan, averaged over the life of the loan. The lower your APR, the lower your repayments will be on the loan you take out.
Annual percentage rate of charge versus interest rate
The interest rate on a loan represents the cost of borrowing regardless of the principal amount. Interest rates are always expressed as a percentage and calculate what the actual monthly payment on your loan will be.
The annual percentage rate, on the other hand, provides a more complete picture of how much you will pay to borrow the principal amount in question, as it reflects the total costs of the loan. The APR is also expressed as a percentage. Lenders are required to disclose their APRs to borrowers, which is why you’ll usually see this information on mortgage documents or credit card agreements.
APR versus APY
When you borrow money, the total amount of interest you end up paying depends on how often that interest is compounded. Compounding is a way of adding interest to the principal of a loan so that more interest can be charged. As an investor, compound interest is a good thing because it allows you to earn more money. As a borrower, however, compound interest is a bad thing because it increases the amount you ultimately pay to borrow money. Generally speaking, the more compounding periods a loan has, the more interest you will pay.
While APR represents the annual interest rate without factoring compounding into the equation, annual percentage yield, or APY, takes compounding into account. APY is a representation of an interest rate based on a one-year compounding period. APR, on the other hand, is a simpler form of interest calculation, as it is obtained by multiplying the periodic interest rate by the number of periods in the year. The greater the difference between APR and APY, the more often the interest is compounded.
Here’s how the concepts relate in practice: If you have a balance on your credit card, you’ll end up paying an APY that’s higher than the APR listed on your card. The reason for this is that interest charges add to your outstanding balance month after month, which means that for each month you have a balance, you will have to pay interest on these interest charges in addition to interest on your capital.
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