The APR is what determines what you will pay for your loan. It’s what the lender charges to use their money for a certain amount of time and it’s what you’ll have to repay with interest.
But, what does APR mean? And, how does APR work?
In this article, we’re going to answer all these questions so that by the end, you’ll know everything there is to know about APRs.
What is annual percentage rate (APR)?
The annual percentage rate (APR) is what the lender charges you to use their money for a set period of time. It’s a yearly cost that’s expressed as a percent.
The annual percentage rate, or APR, is the cost of borrowing money expressed as a yearly interest rate.
It includes not only the interest rate charged by the lender, but also any fees that may be charged for the loan.
The APR allows borrowers to compare the cost of loans from different lenders on an equal footing.
For example, a lender may advertise a low interest rate, but if that loan also has high fees, the APR will be higher than a loan with a higher interest rate but lower fees.
By law, lenders are required to disclose the APR whenever they advertise the interest rate on a loan.
As a result, borrowers can use the APR to comparison shop and make sure they are getting the best deal possible.
Understand APR with examples
Let’s look at a few examples to understand APR.
Let’s say you take out a $1,000 loan with an APR of 10%. Over the course of one year, you would have to pay back the $1,000 plus interest, which would come to a total of $1,100.
That means the APR on this loan is really 10% ($100/$1,000).
Now let’s say you take out a $1,000 loan with an APR of 15%. Over the course of one year, you would have to pay back the $1,000 plus interest, which would come to a total of $1,150.
Even though the interest rate is higher on this loan (15% vs. 10%), the APR is lower because the fees are lower.
The APR can be misleading if you don’t compare apples to apples. In order to make an accurate comparison, you need to look at both the interest rate and the fees involved in each loan.
Let’s look at another example.
If you borrow $10,000 over a five-year period at an APR of 10%, you will end up paying back a total of $12,096. This includes the original loan amount plus interest.
The total amount you pay back each year would be:
$2,419 in Year 1
$2,451 in Year 2
$2,484 in Year 3
$2,518 in Year 4
$2,552 in Year 5
The interest you pay each year would be:
$1,000 in Year 1
$1,021 in Year 2
$1,043 in Year 3
$1,065 in Year 4
$1,087 in Year 5
APR can be a useful tool when comparing loans. It’s important to remember that APR is just one factor to consider when taking out a loan.
Other factors such as the length of the loan, the amount you borrow and the interest rate will all play a role in how much you ultimately pay back.
When taking out a loan, be sure to ask about the APR and compare it to other offers before making a decision.
Types of APRs
There are two main types of APR: nominal APR and effective APR.
Nominal APR is the straightforward interest rate you pay on a loan.
Effective APR is the actual interest rate you pay after taking into account any fees that may be charged for the loan.
For example, let’s say you take out a $1,000 loan with a 10% interest rate and a 3% origination fee. The nominal APR would be 10%. But the effective APR would be 10.3% because of the origination fee ($30/$1,000).
The effective APR is what you should use when comparing loans from different lenders because it takes into account all of the costs associated with the loan.
When shopping for a loan, be sure to ask about both the nominal APR and the effective APR so you can compare loans on an equal footing.
APR is an important factor to consider when taking out a loan. By law, lenders are required to disclose the APR whenever they advertise the interest rate on a loan.
This gives borrowers the information they need to make an informed decision about which loan is right for them.
The effective APR is what you should use when comparing loans from different lenders because it takes into account all of the costs associated with the loan.
How do you calculate APR?
There are a few different ways to calculate APR, but the most common way is to simply take the interest rate and add on any fees that may apply.
For example, let’s say you have a credit card with a 20% interest rate and a $3 monthly fee. The APR would be 20% + 3% = 23%.
You can also use the following formula to calculate APR:
APR = (Interest Rate/100) / (1 – (1/ ((Interest Rate/100) + 1)) ^ (Number of Periods in a Year x Loan Term in Years))) x 100
Using the formula, the APR on our 20% interest rate, $3 monthly fee credit card would be:
APR = (20/100) / (1 – (1/ ((20/100) + 1)) ^ (12 x 1))) x 100 = 23.02%
As you can see, the APR on a loan can be a bit complicated to calculate. But luckily, most lenders will do the math for you and disclose the APR whenever they advertise the interest rate on a loan.
Pros of annual percentage rate (APR)
There are a few reasons why APR can be advantageous:
- It’s the true cost of borrowing money: The main benefit of APR is that it’s the true cost of borrowing money. By law, lenders are required to disclose the APR whenever they advertise the interest rate on a loan. This gives borrowers the information they need to make an informed decision about which loan is right for them.
- It takes into account fees: APR takes into account not only the interest rate but also any fees that may be charged for the loan. This makes it a more accurate representation of the true cost of borrowing money.
- It’s easy to compare loans: APR makes it easy to compare loans from different lenders because you’re able to see the true cost of each loan. This can help you make the best decision for your financial needs.
Cons of annual percentage rate (APR)
There are a few drawbacks to using APR:
- It can be confusing: APR can be a bit confusing and complicated to calculate.
- It’s not always accurate: APR is not always an accurate representation of the true cost of a loan. This is because it doesn’t take into account the time value of money.
- It’s affected by the type of loan: The type of loan you have can affect the APR. For example, adjustable-rate loans typically have lower APRs than fixed-rate loans.
APR can be a helpful tool when you’re considering taking out a loan. But it’s important to remember that it’s not the only factor to consider when making your decision. Be sure to also look at the interest rate, fees, repayment terms and your overall financial needs before you make a decision.
What is a good APR?
The answer to this question depends on a few factors, including the type of loan you’re taking out and what your financial goals are.
Generally speaking, lower APRs are better than higher APRs. But there are some cases where a higher APR may be worth paying if for example, let’s say you’re comparing two loans: Loan A has an APR of 5%, while Loan B has an APR of 10%.
If you plan to pay off the loan within a few years, Loan A may be the better option because it has a lower interest rate and will save you money in the long run.
But if you need a longer repayment period, Loan B may be the better option because it has a higher interest rate but also a longer repayment period. This could make your monthly payments more manageable.
It’s important to remember that the APR is not the only factor to consider when taking out a loan. Be sure to also look at the interest rate, fees, repayment terms and your overall financial needs before you make a decision.
What is a bad APR?
Again, the answer to this question depends on a few factors, including the type of loan you’re taking out and what your financial goals are.
Generally speaking, higher APRs are considered to be bad because they will end up costing you more money in interest over the life of the loan.
For example, let’s say you take out a $10,000 loan with a 5% APR. Over the course of five years, you would end up paying $500 in interest.
Now, let’s say you take out the same $10,000 loan but with a 10% APR. Over the course of five years, you would end up paying $1,000 in interest.
As you can see, the loan with the higher APR will cost you more money in interest over time. So, if all things are equal, it’s always better to go with the loan that has the lower APR.
However, there are some cases where a higher APR may be worth paying. For example, let’s say you’re comparing two loans: Loan A has an APR of 5%, while Loan B has an APR of 10%.
If you plan to pay off the loan within a few years, Loan A may be the better option because it has a lower interest rate and will save you money in the long run.
But if you need a longer repayment period, Loan B may be the better option because it has a higher interest rate but also a longer repayment period. This could make your monthly payments more manageable.
It’s important to remember that the APR is not the only factor to consider when taking out a loan. Be sure to also look at the interest rate, fees, repayment terms and your overall financial needs before you make a decision.
FAQ
When could you encounter APR?
You might see APR in the following scenarios:
- When you’re shopping for a credit card: Credit card companies will often list the APR on their offers.
- When you’re taking out a loan: APR will be listed on loan documents such as the promissory note.
- When you’re reviewing your credit card statement: Your credit card statement will list the APR that was used to calculate your interest charges for the billing period.
APR vs. Interest Rate
The interest rate is the yearly cost of borrowing money, while APR is the total cost of borrowing money, including fees.
For example, let’s say you take out a $100,000 loan with a 5% interest rate and a 4% origination fee. Your APR would be 9% because the origination fee is added to the interest rate.
In this example, your interest rate is 5%, but your APR is 9%. It’s important to remember that the APR is always higher than the interest rate.
What factors affect APR?
There are a few factors that can affect your APR , including:
- The type of loan you’re taking out: The APR on a personal loan will be different from the APR on a mortgage.
- Your credit score: If you have a good credit score, you’re likely to get a lower APR.
- The lender: Some lenders charge higher APRs than others.
- The fees: Some loans come with origination fees or prepayment penalties, which will increase the APR.
- The market: Interest rates can fluctuate, which means APRs can go up or down over time.
Can you negotiate APR?
In some cases, you may be able to negotiate the APR on a loan. For example, if you have a good credit score, you may be able to get a lower APR from your lender.
You can also try to negotiate the fees associated with the loan, which can lower the APR.
APR vs. APY
APR and APY (annual percentage yield) are often confused because they both deal with interest. However, they’re not the same thing.
APR is the interest rate charged on a loan, while APY is the interest rate earned on an investment.
For example, let’s say you have a savings account with a 5% APY. This means that you’ll earn 5% interest on your savings each year.
On the other hand, let’s say you have a credit card with a 15% APR. This means that you’ll be charged 15% interest on any outstanding balance on your credit card.
So, APR is the interest rate charged on a loan, while APY is the interest rate earned on an investment.
Final thoughts
When you’re shopping for a loan, it’s important to understand what Annual Percentage Rate (APR) means. APR is the total cost of borrowing money, including fees.
It’s always higher than the interest rate and can be affected by a variety of factors, such as your credit score and the lender you choose.
You might also see APR in relation to APY, which is the interest rate earned on an investment.
Keep in mind that the APR is not the only factor to consider when taking out a loan.
Be sure to also look at the interest rate, fees, repayment terms and your overall financial needs before you make a decision.
