What is the APR (annual percentage rate)?
Whether you’re applying for a credit card or calculating the expected return on an investment, three simple letters have a big impact on your decision: APR. What is APR? It represents the annual percentage rate of charge. It represents the amount of annual interest paid to investors or owed by borrowers. It is a figure that includes costs and fees, but does not take into account capitalization. Therefore, it is an excellent baseline for comparing the creditworthiness of investments or the cost of different credit products.
When assessing the APR, borrowers and investors should be aware of how it affects their wealth based on the principal balance. Here’s what you need to know about APR, as an investor and a borrower.
APR for investors
From an investment perspective, the APR represents the uncompounded rate of return for the year, expressed as an interest rate. For example, the APR of a bond maybe 6%. This means that you can expect to earn 6% on this investment every year.
APR is straightforward when comparing similar fixed rate investment products, such as bonds or certificates of deposit. These products are available at a specific face value and come with an interest rate (coupon) that bounds their APR. By looking at the interest rate, investors can make smart decisions about where to put their money. For example:
Rashmit wants to invest in bonds. He has the choice between a $5,000 bond with a rate of 5% and a $3,000 bond with a rate of 8%. Option A will earn him $250 per year, while Option B will earn him $240 per year.
This example illustrates the importance of principal on APR. Although option B has a higher APR, the principal is smaller. Option A has a lower APR, but the return is higher due to the higher principal amount.
APR for borrowers
The APR for borrowers is the same concept, applied only in reverse. You pay the APR to borrow money. This can be very important depending on the type of loan. For example, mortgages can be as low as 2.8% APR, while credit cards can average 24%. It is extremely important to shop around for the best rate, to avoid paying high interest rates when borrowing.
How APR works for borrowers is a bit complex. Take the APR credit card, for example. Credit cards are compounded daily, using the average daily balance. The credit card interest formula is the daily rate multiplied by the average daily balance multiplied by the days in the billing cycle. The results of this equation can add up quickly. For example, a balance of $5,000 at an APR of 24% would take 36 months to be paid off if you were paying $200 per month, and that would be $2,000 in interest payments!
APR for borrowers also takes several different forms: purchase APR, introductory APR, penalty APR, and upfront APR, to name a few. These are all criteria-specific APRs, which can alter your assessment of different financial products.
Fixed or variable APR
When talking about different types of APRs, the biggest differentiator between them is often Fixed vs Variable APR. As the name suggests, the fixed APR remains the same for a predetermined period of time. Variable interest rates are, in a word, variable. They can go up or down depending on different factors, and usually within a specific range. Variable APRs adjust based on the prime rate, which can often fluctuate.
Lending products and fixed income investments can offer a fixed or variable APR. It is up to each individual to evaluate the products available to them and decide which pricing structure is ideal. For example, buying a house with a variable APR when rates are historically low can be a smart way to reduce the total interest paid over the life of the loan. Conversely, an investor may prefer a fixed coupon bond with an attractive APR that they can hold or resell for a premium.
APR vs. APY: What’s the difference?
There is often some confusion between annual percentage rate and annual percentage return. The difference is that the APR measures the annual unfunded rate, while the APY represents the rate of return with composition. The main difference to remember between APR and APY is that APY increases as the main balance increases after each compounding. For example:
Marcy invests $1,000 in a fund that has an APR of 12%. This means that his monthly rate of return is 1%. If these revenues are compounded monthly, the APY actually comes out at 12.68%. This is because the principal balance increases monthly. The APR remains the same, the APY changes.
Investors (and borrowers) should know the difference between APR and APY as it affects the prospectus of an investment. In fact, the Truth in Savings Act of 1991 requires lenders and borrowers to disclose both numbers, so investors can make an informed decision.
Calculation of annual percentage rates
The APR formula works by multiplying the periodic interest rate by the number of periods in a year. The formula for calculating the APR East:
- Add the interest paid over the term of the loan to any additional charges
- Divide by loan amount
- Divide by the total number of days in the term of the loan
- Multiply by 365 to find the annual rate
- Multiply by 100 to convert annual rate to percentage
Remember that this formula does not take capitalization into account. To calculate the composition in the equation, it is important to calculate APY instead.
Pay attention to annual percentage rates
Whether you are borrowing or investing, it is important to pay close attention to the APR. What is APR? It is the annual interest generated by a principal balance. Beyond the rate itself, check whether it is fixed or variable, and what conditions stipulate this rate.
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The APR can be a useful tool for evaluating financial products. You just need to make sure you understand it and make sure you are comparing APR to APR, not APY.