You’ll hear lots of new terms when you apply for a loan or credit card. Annual percentage rate, or APR, is one you should definitely understand.
What’s the definition of APR? The annual percentage rate is what your lender charges you to borrow money on a yearly basis. It includes both your interest rate and any fees the lender tacks on. Put another way, APR is the annual “price” of borrowing money.
Here’s how APR works in very basic form. Imagine you take out a $20,000 auto loan at 7.5% fixed APR for 5 years and the lender charges you no additional fees.
Assuming you make all your monthly payments on time, by the end of the loan term, you’ll have paid your lender about $24,000. $20,000 for the original loan amount and a little over $4,000 in total interest charges. The actual price, or cost, of the loan is close to $4,000.
Of course, credit cards are a bit different. If you pay your balance in full each month by the due date, you can avoid interest on purchases entirely. In this scenario, your APR has no effect on the cost of borrowing money.
Why Is Knowing Your APR Important?
When you know your APR, you know the “true” cost of your loan.
Let’s say you get mortgage loan offers from two lenders.
|Loan 1||Loan 2|
Both lenders offer you a 3% interest rate. So, at first glance, you assume both loans are the same. Then you check out the APR, and you see that Loan 1 comes with an APR of 3.2% and Loan 2 comes with an APR of 3.7%. This is where things get … interesting!
Yes, the interest is the same, but Loan 2 may charge more in fees, which would make your mortgage loan more expensive. If you opt for Loan 2, you may pay more in interest on the money you plan on borrowing.
Loan 1 has a lower APR than Loan 2. While you may pay less in fees and associated costs, you may have to make a large down payment (think: the percentage of the sale price you pay upfront to buy a home), or you’ll need a higher credit score to qualify for the 3.2% APR.
Because APR includes more than the interest rate, it makes it easier to “look under the hood” of your loan to see what the real cost of borrowing will be. That makes it simpler to make an apples-to-apples comparison when you’re looking at different loan offers.
How is Your Mortgage Interest Rate Different from the APR
Mortgages are long-term, high-value loans – we’re talking hundreds of thousands of dollars in some cases. You’re going to be paying back that loan. It’s important to understand the difference between your mortgage interest rate (aka your mortgage rate) and your APR because it could save you thousands.
Your mortgage rate is set by economic factors and doesn’t include the full cost of fees that come along with borrowing money to buy a house.
Mortgages involve closing costs – like origination fees, underwriting fees and other expenses – that your lender will charge you for. These costs typically range from 4% – 6% of your mortgage loan and get added to the loan’s balance. APR includes these fees, which vary from lender to lender.
Pro tip: If you pay for mortgage origination points upfront (that usually requires a 20% down payment) you can lower your interest rate and your APR.
Whether you choose to pay more upfront or over the loan’s term (or length), APR represents the thousands or tens of thousands of dollars you’ll pay over the life of your mortgage.
What’s the Difference Between Simple and Compound Interest?
When you borrow money, your interest charges are calculated as either simple interest or compound interest. The type of interest your lender or credit card issuer charges can have a big impact on your overall cost of financing.
Many installment loans, such as auto loans and student loans, are simple interest loans. When you make your payment each month, the interest you owe is paid in full and the remainder of your payment reduces the principal loan balance by some amount.
If you make your monthly payment early, your interest charges are typically lower and more of the payment goes toward your principal debt.
With compound interest, interest charges are calculated on both the outstanding balance, including new purchases and fees, and the interest charged on that balance. You end up paying interest on your interest.
Most credit cards and revolving lines of credit use compound interest. As a result, you may actually pay a higher APR on your credit card debt than the interest rate listed in your card agreement.
Here’s how it works: Imagine you charged $1,000 in new furniture on a credit card with a 20 % APR. If the bank only charged credit card interest once per year, you’d pay about $200 in interest ($1,000 x 0.20 = $200), assuming there were no additional fees.
But with many credit cards, interest is compounded on a daily basis. Using the daily balance method, your card issuer would calculate your average daily balance and multiply it by your daily periodic rate (your credit card APR expressed as a daily value: APR ÷ 365). Then, the issuer would add those interest fees to your outstanding balance.
If you don’t pay your credit card balance in full each month, the “interest on interest” fees would effectively drive up the actual interest rate on your card. That’s the hidden danger of compound interest from a personal finance point of view.
The only way to avoid the negative effects of compounding interest on your credit card debt is to pay your balance in full each month by the due date. Card issuers typically offer a grace period, during which no interest is charged on purchases — as long as you pay your statement balance in full by the due date.
What Is the APR Formula?
There is no one answer to this question because different lenders use slightly different formulas based on the loan. But, here’s a simple formula you can use to check (and double-check) their math!
APR = [((fees + interest) /loan principal) / number of days in loan term] X 365 X 100
Or, you can break out the calculator (trust us, you’ll need one) and follow these steps:
- Take the total interest that will be paid over the life of the loan (you can use a personal loan or mortgage loan calculator to get this number) and add any fees.
- Take that number and divide it by the loan’s principal (think: the amount you borrowed to buy the home).
- Divide that result by the total number of days in the loan’s term or length (If you’re counting in years, don’t forget about leap years.)
- Multiply that number by 365.
- You should get a decimal number. Multiply that decimal number by 100, and you’ve got the APR!
See, we told you it wasn’t magic.
What Is a Variable APR Loan or Credit Card?
Just as simple versus compound interest determines the true cost of borrowing money, fixed versus variable APR plays another important role.
A fixed APR means that you pay the same interest rate for the entire term of the loan. With a variable rate loan or credit card, however, your interest rate can go up or down depending on the prime rate or other index chosen by your lender. Variable rate financial products can be attractive because they often come with low introductory rate APRs.
Here’s how variable APR works. Your bank or credit card company pegs the annual interest rate to a financial index. From there, it adds a fixed amount, known as a margin, to determine your APR.
Most variable-rate loans are based on the U.S. prime rate, which is the lowest APR banks charge their most credit-worthy customers. However, other indexes, like the Secured Overnight Financing Rate (SFOR), are sometimes used as well.
Imagine the margin on your variable APR credit card is 14%. If the prime rate is 4.75%, your interest rate would be 18.75% (index rate of 4.75% + 14% margin). Depending on the lender and the terms of your credit card agreement, your rate may be recalculated on a monthly, quarterly or yearly basis.
When the financial markets are relatively stable, you may not see huge swings in your variable rate loans. But when the markets are in turmoil, you may see big jumps in variable-rate financial products.
Be sure to find out which consumer protections come with your loan if you are considering a variable rate financial product. In particular, look for interest rate caps, which limit the amount your APR can increase over a particular period of time.
What Are the Different Credit Card APRs?
Most credit cards have multiple APRs for different situations. Here are a few of the most common APRs you may see on your monthly statement:
- Purchase APR: This is the most common type of APR that you’ll see. It’s the interest rate you’ll be charged on purchases if you revolve a balance from month to month.
- Introductory purchase APR: This is a lower APR that applies to new purchases made for a certain period of time after you open a new account. It’s one of the most popular credit card offers lenders use to attract new customers. You’ll find many cards with 0% APR introductory rates.
- Promotional APR: Promotional rates are special rates offered for a short period of time or on certain types of balances. Sometimes this term is used interchangeably with introductory APR.
- Balance transfer APR: Some credit card companies can help you save money with a lower APR on balances you transfer from another card to a new or existing account with that company.
- Introductory balance transfer APR: Some credit cards designed for balance transfers offer 0% or low intro rates on balances you transfer from other accounts. Usually you need to complete the transfer within a few months after getting your new card to be eligible.
- Cash advance APR: Most issuers charge a higher APR on cash you borrow on your card than on your regular purchases. You’ll also typically pay a cash advance fee, driving up the cost of this type of transaction.
- Penalty APR: In some cases, your credit card company may bump your APR to the highest APR allowed on your agreement. This is generally due to multiple late payments or consistently running a balance above your credit limit. The average penalty APR is around 29.99%, and currently no law limits the penalty rate banks can charge. However, the CARD Act does require card issuers to disclose the cost of penalty APRs in advance. After 6 months of on-time payments, card issuers must also lower your APR back to the standard rate.
There’s something else you should keep in mind about your minimum monthly payments and the different APRs on your credit card balance. By law, the minimum monthly payment must be applied to the highest APR balance on your credit card. Yet, if you pay more than your minimum, that amount can go to balances with lower promotional APRs.
What Can I Do to Get the Lowest APR?
Remember, for most credit cards the purchase APR doesn’t matter as long as you pay off your purchases in full each month, as we recommend.
If you already have credit card debt and want to reduce the APR you’re paying, consider a balance transfer. A balance transfer is like paying one credit card with another. You can sometimes get an introductory 0% APR offer for balance transfers, which could save you significant money on interest while you pay off debt.
If you’re planning to make a big purchase and know you’ll carry a balance, consider cards with a 0% introductory APR on purchases. You can avoid interest completely as long as you pay off the full balance before the 0% period runs out. Just keep in mind that if you have a high credit utilization rate, it could hurt your credit scores in the meantime.
The lowest regular APRs, including the longest 0% introductory offers, are usually only available to people with good credit. Most popular credit scoring models use a scale of 300 – 850 to indicate creditworthiness. Generally speaking, FICO® credit scores above 670 are considered good, while those below 580 are considered bad.
People with bad credit may have trouble qualifying for credit or getting a decent interest rate. However, a secured credit card could be a helpful way to rebuild credit, if you find yourself in this situation.
Credit scoring models base your credit scores on several different factors:
- Your payment history: Even one late payment can affect your credit scores. The more recent or more severe the late payments on your credit reports become, the worse the impact on your credit scores will be.
- Credit utilization: If all your credit cards are maxed out, your scores will almost certainly take a hit. Lenders like to see plenty of available credit on your credit card accounts.
- Length of credit history: The longer you’ve had credit — and managed it wisely — the better your scores will generally be.
- New credit inquiries: If you apply for a lot of new accounts over a short time, lenders and credit scoring models may see it as a red flag or an indication that you could be desperate to borrow money. If you’re looking for a new card, avoid getting too many inquiries on your credit reports by applying tojust one or two companies.
If your credit scores are on the low side, you can take steps to improve them. One of the most actionable ways to potentially improve credit scores is to pay your credit card balances in full each month and keep your utilization low.
If you can’t pay your full credit card balance, make sure you pay at least the minimum due by the due date. Late payments are terrible for your credit scores and might cause your issuer to increase your APR or close your account. If you’re 60 days late, they can charge a penalty interest rate on your entire balance. If this happens to you, don’t despair — it won’t last forever as long as you make on-time payments going forward.
If you have debt now or plan to carry a balance, but can’t get approved for a card with a 0% introductory offer, the next best option might be a card with a low interest rate on purchases, balance transfers, or both.
If you’re a member of the military, you may have other options to reduce the interest rate on your card.
Frequently Asked Questions
What’s a good APR?
There’s no clear answer to this question. The interest rate you’re charged is usually dependent on your credit scores, the economy, the type of loan or credit card in question, and several other factors. An APR might be considered “good” in one situation but extremely high or low in another.
With respect to credit cards, lower is better, and the best APR is 0% APR. Take advantage of your grace period and always pay your statement balance in full by the due date, and you can avoid accumulating interest altogether, so your APR won’t matter. You may also be able to find cards that provide temporary 0% introductory APR offers for purchases and/or balance transfers. Try to avoid using a credit card altogether if you’ll have to carry a balance at interest.
But, if you really need an idea of a “good” credit card APR, research the national average credit card APR. This number can change significantly based on the economy. An APR around the national average or lower can generally be considered good.
Do the same for loans and mortgages. These numbers change frequently, so the best way to get an idea of what’s good is to check the current statistics.
What’s the difference between interest and APR?
When it comes to loans (particularly mortgages) “interest” refers specifically to interest charges, and that’s it. APR, which stands for annual percentage rate, encompasses the cost of the loan as a whole, including interest and costs like a broker’s fees.
That’s not how APR works with credit cards. Typically, your issuer will clearly list each type of APR separately in your card’s terms. You might see purchase APR, balance transfer APR, and various other costs or fees. This information should also be accessible online and through the issuer’s mobile app. In these cases, “APR” refers strictly to an interest rate, and doesn’t take fees into consideration.
Can you avoid APR charges?
Yes, you can avoid interest! With credit cards, at least. That’s thanks to a nifty feature called the grace period, which is basically a stretch of time after your statement is generated, and before your payment due date, during which you won’t accumulate interest charges.
Here’s how it works:
- You make a purchase, or several purchases, amassing a credit card balance.
- Sometime within the next 30 or so days, on the statement closing date, your full statement balance is calculated. That’s the total balance from that period (which could be different from current balance).
- You get a due date by which you must pay at least the minimum amount due. This is also the date by which you must pay off the full statement balance to avoid interest.
- You pay off the statement balance in full, and you’re therefore not charged interest.
- If you don’t pay the full statement balance, you’ll be charged interest on the remaining balance, and will likely lose your grace period.
If you need to float a balance over a longer period of time, or pay off a debt that’s currently incurring interest charges, look for a card with a 0% introductory rate on purchases or balance transfers.
You can’t usually avoid paying interest on loans, unfortunately.
What is my credit card’s APR?
There are several ways you can figure out your credit card’s APR.
Thanks to the Truth in Lending Act (TILA), all lenders must disclose their APR to borrowers for every type of consumer credit including mortgages, auto loans and credit cards before they accept an offer.
You should have received your card’s terms by mail upon approval. Those terms should include something known as a Schumer Box, which should clearly detail your card’s APRs, plus any relevant fees.
Your card’s current APR should also be included with your statement, whether you receive it on paper or online, it should give you a breakdown of:
- The amount financed: The amount of money you’re planning to borrow.
- Finance charges: The total cost of borrowing (represented as a dollar amount).
- Payment and loan term information: This includes your monthly mortgage payment, the number of payments you’re required to make and the total amount you’ll pay over the life of the loan.
- Other information: The lender is required to disclose any late fees and prepayment penalties.
Other ways to check your card’s APR (plus related information) include logging in to your credit card account online, or by using the issuer’s mobile app.
Don’t have a credit card yet? Issuers tend to list the range in which your APR will fall on the card’s official webpage, or in the card’s terms, which are usually accessible from that webpage. But you won’t get a specific number (in most cases) unless you’re actually approved.
APR: Final Thoughts
And just like that, you know the difference between interest (what you’re charged to borrow money) and APR (interest plus added fees and costs). It’s important to feel confident about how APR works. You don’t want to wake up one day and wonder how a loan or credit card ended up costing so much more than you anticipated.
Consumer Financial Protection Bureau. “What is a Truth-in-Lending Disclosure? When do I get to see it?” Retrieved January 2022 from https://www.consumerfinance.gov/ask-cfpb/what-is-a-truth-in-lending-disclosure-when-do-i-get-to-see-it-en-787/