APR: What Is It & Why Does It Matter?
Scott Steinberg6-minute read
November 05, 2020
If you’ve ever taken out a loan or opened a new credit card, then APR is a term you’ve probably heard before. But what is APR, or annual percentage rate? It’s the rate at which your loan will accrue interest over the loan term. It’s not a single interest rate, but rather compiled of multiple rates and fees.
In this article, we’ll break down everything you need to know about APR, including different types; what APR does and doesn’t include and how to calculate your APR.
What Is APR?
As the name suggests, APR is a percentage that represents the per-term cost of borrowing money. It can be thought of as an umbrella word for a number of different interest rates and fees that will be applied to your loan or line of credit during its lifetime. For most loans, this may include any or all of the following
- Document preparation fees: The fees your lender charges you in order to prepare your loan
- Underwriting fees: Covers the cost of figuring out if you’re eligible for a loan, such as pulling your credit score, bank statements and tax returns
- Origination fee: An umbrella term that includes any fees covering the cost of approving and processing your loan application (i.e., service charges)
- Closing fee: The cost of packaging your loan, as well as real estate valuations (among other items) if that loan is a mortgage
- SBA loan fee: Paid by your lender to the Small Business Administration and added on to your APR to cover the expense
Thanks to the Truth in Lending Act of 1968, lenders are required by law to disclose the APR for any loan they offer before the transaction is finalized. This makes it easier for customers to compare APRs as they shop around. The one caveat to keep in mind is that, because not every lender includes the same fees in their APR, you may have to do a bit more research to determine the true value and cost of a loan offer.
APR vs. Interest Rate
The main difference between APR and the interest rate charged to a loan is that the latter is charged to the loan principal. Because the APR includes the loan interest rate, as well as all of the other charges and fees listed above, it's a higher percentage. Fortunately, you don’t have to worry about dividing your payments between interest and APR – they’re paid down simultaneously.
APR vs. APY
Although they may look similar, it’s important to note that a loan’s APR is not its APY, or annual percentage yield. APY is the rate of return you can expect to earn from a savings deposit or investment. Unlike APR, it takes compounding, which is the process of reinvesting an investment asset’s earnings, into account. Because of this, APY is typically larger than APR. Additionally, APY is interest you’re earning rather than interest you have to pay down.
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How Do You Calculate APR?
If you’re shopping for a loan, then it’s a good idea to know exactly how APR is calculated. Having a firm grasp of the concept will better inform your search, and it never hurts to check the math! If you know the amount of fees and interest you’ll be expected to pay on a loan, then determining the APR is relatively simple:
1. Add the fees and total interest to be paid over the life of the loan.
2. Divide that sum by the loan principal.
3. Divide that result by the total days in the loan term.
4. Multiply the result by 365.
5. Multiply that by 100 to get the APR as a percentage.
Here is an example:
1. $360 in interest + $50 in fees = $410
2. $410 / a principal of $3,000 = 0.13666667
3. 0.13666667 / a term of 180 days = 0.000759
4. 0.000759 x 365 = 0.277
5. 0.277 x 100 = APR of 27.7%
It’s important to note that APR is influenced by your credit score. As with most credit-related things, the higher your score, the lower the APR applied to your loan. Because of this, it can be a good idea to work on improving your score before taking out a loan, if you can afford to wait.
What Are The Different Types Of APR?
The specific rates and terms of an APR vary depending on the type of loan it’s attached to. The two main types of APR are fixed and variable.
What Is Variable APR?
The interest rate of a variable APR is subject to change at any time during the term of the loan, usually in response to market interest rate fluctuations. This means your APR payments will change as well.
What Is Fixed APR?
Conversely, a fixed APR stays the same from the moment your loan is finalized until it’s been paid in full. The interest rate is set by whatever the market rate is at the time the loan was closed. With a fixed APR, you’ll never be taken by surprise should the market interest rate rise. On the other hand, if the rate falls below what it was when you received your loan, you’ll still be paying the higher rate.
What About Credit Cards?
APR grows more complicated with credit cards. The lender is free to charge a different APR for each type of transaction, such as one for purchases, one for cash advances and one for balance transfers. Lenders also charge a high-rate penalty APR should the borrower miss a payment or violate the terms of their credit agreement.
Why Does APR Matter?
If you don’t pay attention to the APR when shopping for a loan or credit card, you could end up paying substantially more over the long term. A loan with an interest rate of 5% and an APR of 10% will still cost you more than one with 6% interest and 9% APR.
The terms of an APR may also influence how you use a new credit card. If there’s a 0% APR introductory grace period, for instance, you may want to make larger purchases during that time. As long as you pay them off in full before the grace period ends, you’ll be saving money by not having to pay the APR. Just be sure you can pay off those purchases quickly, otherwise you’ll be saddled with the high interest payments once the grace period ends.
Shortcomings of APR
Although it’s important to pay attention to, you shouldn’t assume that APR is an accurate indicator of the total cost of borrowing a loan. Why? APR is calculated assuming the loan will be paid off using a long-term repayment schedule. If you opt for a shorter-term schedule, then the actual cost of the loan will be much lower. Monthly payments on a 30-year mortgage will be much smaller than on a 10-year mortgage, for example, because they’re being spread out across a longer term as small payments. But you’ll be paying much more in interest over the life of the loan.
For much the same reason, adjustable rate mortgages (ARMs) are not always accurately reflected in the APR. After their fixed-rate period has ended, the interest rate of an ARM is subject to change. This clashes with the APR, which is estimated based on a fixed interest rate. Do your due diligence if applying for an ARM and figure out what your APR might actually be for the lifetime of the loan. The best way to do this is to calculate the APR based on the maximum interest rate possible at each adjustment.
Finally, because lending institutions can decide which fees to include in the APR, it’s difficult to truly compare similar loans and credit cards by APR alone. You’ll need to figure out what’s being included in the APR before you can decide which loan has the better terms. As a general rule, however, the bigger the difference between interest rate and APR, the higher the loan cost.
Get Started: Find The Right Mortgage APR
There are many factors to consider when shopping for a loan, and the APR is definitely one you should not overlook. Be sure you have a firm grasp on the concept of APR, and do the research required to understand the full cost of borrowing. If you’re looking to compare your options, get started online.
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