Whether it is mortgages, car loans or credit cards, you have probably seen APR or annual percentage. Understanding how APRs work can help you get better financial decisions when borrowing money. We’ve hit rock bottom.
According to the Consumer Financial Protection Agency (CFPB), an APR is the price you pay for borrowing money. In other words, it’s the annual rate you pay when you carry a balance, and it can vary from lender to lender. For example, suppose you have two credit cards. One card’s APR may be 10.99% and another card’s APR may be 15.99%. Your creditworthiness is taken into account by creditors when determining your APR, with a higher credit score generally resulting in a lower rate.
You may see your credit card rate fluctuate over time if you have a variable APR. In general, variable APRs are based on some type of index, such as the prime rate, which is the lowest rate at which banks lend. The APR on your card will increase if the prime rate rises and vice versa if the prime rate falls.
How APR works
In finance, an annual percentage is commonly referred to as an interest rate. By taking monthly payments into account, it calculates how much of the principal you pay each year. An APR is also the interest paid each year on investments without taking compound interest into account.
For example, there is usually a grace period for new purchases with credit cards. No interest is charged if you only make purchases and pay your closing balance each month on the due date. If, on the other hand, you have an outstanding balance on your card, you will be charged the agreed interest each month.
Since 1968, the Truth in Lending Act (TILA) has required lenders to disclose their interest rates to borrowers. The interest on a credit card is advertised every month. However, the APR must be clearly displayed before an agreement is signed by the customer.
APR vs. Interest Rate
There is a common misconception that interest and APR are the same. But in fact they are two different entities.
You pay an interest rate based on the principal of your loan. With a credit card, your balance would be the amount borrowed.
Unlike interest rates,APR is a broader measure of the cost of borrowing money,” explains the CFPB. In addition to the interest, other costs may apply, such as lenders, closing costs and insurance. For credit cards, the APR and the interest rate are usually the same as there are usually no lender fees.
APR vs APY
APY is also a term you may have heard. Despite the fact that it may look like APR, it is actually something completely different.
An APY is an annual percentage return. In some cases, this is called EAR or effective annual rate. The APR tells you how much interest you will be charged when you borrow. On the other hand, the APY/EAR tells you how much interest you will earn when you save. Therefore, APY/EAR usually applies to deposits, not loans.
How is APR calculated?
Depending on whether you have a credit card or an installment loan, the calculation of your APR will vary. Below is a comparison of the two.
How Credit Card APRs Work.
Credit card issuers usually base your APR on your credit score, the type of card, and how the card will be used. Although in some cases they may offer one rate to all applicants. Card issuers typically calculate your APR based on how risky you are as a borrower. This is a concept known as risk-based pricing.
If you don’t pay your monthly bill in full, the credit card interest will be applied to your balance. The daily interest on your credit card is calculated by dividing your APR by 365.
Let’s say you have an average daily balance of $5,000 of 15.99%. In a 30-day billing cycle, your daily period rate is 0.0438% (15.99% divided by 365). Based on the formula of DPR (0.0438) multiplied by the number of days in the billing cycle (30) multiplied by the average daily balance ($5,000), the monthly interest calculation would be as follows:
(0.0438%) x (30) x ($5,000) = $65.70 in interest expense for the month.
If you make purchases throughout the month, your daily interest is compounded daily until the statement period ends.
How installment APRs work.
The interest rate on a loan is how much the lender charges you for borrowing money. Also, like credit card companies, lenders determine your interest rate based on your creditworthiness. However, borrowing is not only about interest costs.
For example, a mortgage APR may contain points, which are fees paid to lenders at closing to lower interest rates. You may also have to pay lenders or other fees to secure the loan. A car loan APR can take into account the dealer’s fee.
In addition, some personal loans may require you to pay an initial fee. This fee is deducted from the proceeds of your loan before you receive it. It is for this reason that the APR of a loan is usually higher than the interest.
In short, different loan types and fees can affect the APR calculations.
Types of APR
For credit cards and loans, there are many types of APR. In addition, different lenders charge different rates.
The following is how each type of APR works:
- buy APR. In simple terms, purchase interest is the rate charged for purchases made with a credit card.
- Balance transfer APR. This is the APR you pay when you transfer a balance from one credit card to another. In most cases it is the same as purchasing APR.
- Promotional or Introductory APR. Several credit cards offer introductory low or 0% interest rates on purchases and balance transfers to entice new customers.
- Cash advance APR. When you borrow money from your credit card, you pay the cash advance APR. Usually it is higher than the purchase APR. Cash advances can include other types of transactions, even if you don’t actually handle cash. Exchanging dollars for foreign currency, buying casino chips or buying lottery tickets are all examples of these activities. A grace period usually does not apply to these transactions. As a result, you will likely start accruing interest right away.
- Penalty APR. By missing a payment or being late with a payment, you can violate the terms of the card’s contract, causing your APR to increase for a period of time.
- Fixed APR. The interest rate for this type of loan remains the same throughout the life of the loan. When it comes to installment loans, it is common. But when it comes to credit cards, it’s an anomaly.
- Variable APR. These fluctuate with market interest rates, so they can rise over time. Most credit cards have this type of APR, and so do some installment loans.
What Affects Your APR?
Your APR is affected by many factors, some of which you can control and some you cannot:
- Credit history. If you have a bad credit history, lenders may charge you a higher interest rate.
- Income. To determine whether you can afford additional debt, lenders look at your debt-to-income ratio (DTI). Your application may be rejected if you have a high DTI.
- Fees and Other Expenses. Lenders may charge fees on top of your interest rate, which would increase your APR.
- Great rate. Lenders use the prime rate as a comparison when determining interest rates. It is directly affected by the Federal Funds interest rate set by the Federal Reserve. New loans can be affected by the prime rate. But don’t open accounts unless the APR is variable.
- type of loan. Obviously, some loans charge higher APRs than others. For example, mortgages and auto loans tend to have lower APRs. This is because your house or car serves as collateral, which reduces the risk for the lender. Conversely, unsecured loans such as personal loans, credit cards, and payday loans tend to have higher interest rates.
Tips for getting a lower APR card
What’s the best way to get a credit card with a low APR? There is not one answer that suits everyone. However, maintaining a good credit score can also lead to low interest rates and other benefits.
Building or repairing your credit isn’t easy, these guidelines from the Consumer Financial Protection Agency can help:
- Pay your bills on time and use your current card responsibly. Your credit score can be negatively affected by late payments. Consider setting up automatic payments to make sure you don’t forget to pay.
- Do not exceed your credit limit. Your “maxing out” status is taken into account in scoring models. According to experts, you should not use more than 30 percent of your credit limit. So if you have a card with a $5,000 credit limit, the balance should be about $1,500.
- Constantly building. Your credit score is based on your credit history. In other words, the longer your credit report shows you are paying your loans on time, the better your credit score will be.
- Do not take out more credit than you need. Taking out a lot of credit in a short time is not a good idea. In some cases, it indicates to lenders that your financial situation has deterioratedeven if that’s not true.
- Keep an eye on your credit score. Every 12 months, each of the major credit bureaus should provide you with a free copy of your credit report. If you discover an error, contact the company and agency that provided the information to attempt to resolve the issue.
Frequently Asked Questions about APR
1. What is APR?
APR stands for annual percentage. It is a calculation of a loan’s interest rate and a loan’s borrowing cost over time – the total cost of credit. APR is good for interest, costs and time. If your APR is similar to the interest rate you show that the lender is not charging additional fees.
2. Why is APR important?
If you are taking on a debt, it is very important that you understand the APR as it is the cost of borrowing money.
In general, you should avoid debt with high APRs, as the costs can exceed your budget.
3. What is a good APR?
When determining a “good” APR, factors such as competitive rates in the market, the central bank’s prime rate, and an individual’s credit score are taken into account. Many companies in competitive industries, such as car dealerships, offer 0% APRs on car loans and leases when prime rates are low. It is important for customers to verify that these low rates are permanent or are simply introductory rates that will be replaced by higher APRs after a period of time. It’s also possible that customers with particularly good credit scores can only get low APRs.
4. Why is the APR published?
To prevent companies from misleading customers, consumer laws require companies to disclose their APRs.
Suppose a company advertised a low monthly interest rate without disclosing the annual percentage rate. The customer can be misled by comparing an apparently low monthly rate with an apparently high annual rate. To provide customers with an “apples-to-apples” comparison, all companies must disclose their APRs.
5. Where can you find your account APR?
Account opening disclosures and monthly credit card statements include your credit card APR. Your current APR can often be found by looking at the interest expense section, which tells you if it’s based on the prime rate.