Annual Percentage Rate Explained: What is APR & how does it work?

Posted 17.05.2023

Annual Percentage Rate Explained: What is APR & how does it work?

If you’re shopping around for a credit card or a loan, you may have come across the term APR. Be it with credit cards, personal loans, auto loans, or mortgages, a solid understanding of what APR is can help you save more.

To guide you in choosing the best loan, this article covers what APR means, how it works, and what a good APR is.

What is APR?

The annual percentage rate (APR) shows the total annual cost of your loan, including the interest rate and any additional fees you may incur. So, if you have a 4% origination fee and a loan application fee, the APR factors in these charges. Meaning the higher the APR, the more expensive the overall loan is.

Credit card APRs are quite different though. It refers to the interest that credit card issuers charge if you fail to pay off your full balance. Usually, the credit card APR doesn’t include other fees, such as annual fees, late payments, and more.

Imagine your credit card bill arrives, and you owe $450 for the month. If you only settle half of it, you will be charged for your remaining balance.

In general, the APR acts as a benchmark when comparing loans or credit cards from lenders and credit card companies. Let’s assume a personal loan with an 8.65% interest rate and application and origination fees. Depending on the extra charges, your APR would be higher than 8.65%.

To protect you from false advertising, the Truth in Lending Act (TILA) of 1968 requires lenders to disclose the APR and other charges. This gives you a clearer picture of the total cost of your loan over the term.

How does the APR work?

Aside from the principal amount and interest charges, you typically need to pay other fees when you apply for a loan. These can include application, origination, and lender fees. The APR considers these additional costs, so a 12.99% interest rate may actually cost you around 14.75% annually.

A lower APR means you will pay less interest over the life of the loan. So, comparing APRs and other fees before applying can help you find the ideal loan you can afford.

Though, with credit cards, the APR is the interest charged on your unpaid balance. Let’s say your credit card’s APR is 20.22%, and you have an outstanding balance of $500. If you don’t pay off your current balance in full, your credit card issuer would charge you interest on your remaining balance.

With a 20.22% APR, your monthly interest can reach around $8.38 for your billing cycle. The interest you accrue would stack up fast if you don’t pay your balance for more months. Because of this, it’s important to settle your credit card balance to minimize the interest you accrue.

How is APR calculated?

Calculating your APR differs based on what financial product you’re applying for:

How is installment loan APR calculated?

Calculating the APR on installment loans, such as personal and auto loans, depends on your principal, interest, and loan fees. Since the APR on a loan includes extra costs (i.e. discount points, origination fees, etc.), make sure you review the terms and conditions.

Let’s compare three $10,000 loans from different financial institutions:

	Lender 1	Lender 2	Lender 3
Interest rate	9%	10%	11%
Origination fee	5% ($500)	4% ($400)	3% ($300)
Total interest	$1,447.90	$1,616.19	$1,785.94
APR	12.37%	12.72%	13.06%

Given these examples, the first lender’s origination fee is higher than the second and third lenders’. But since the APR and the overall interest of the first lender is lower, it becomes the cheapest option among the three.

This is how APR comes into play when comparing loans. Generally, the option with the lowest APR would cost you less over the life of your loan.

How is credit card APR calculated?

To calculate your credit card interest, divide your APR by 365. This will give you your daily interest. For example, if your APR is 18.99%, divide it by 365 to get your daily interest rate, which is around 0.052%.

If your outstanding balance is $500, multiply this amount by 0.00052. So, your daily interest approximately costs $0.26. To estimate your monthly interest rate, just multiply your daily interest by the number of days in your billing cycle.

Remember that the daily interest increases each day until your statement period because of compounding interest. To avoid paying interest, try to pay your full balance on every due date.

APR vs. interest rate

The annual percentage rate and the interest rate differ when comparing rates for installment loans, such as personal and auto loans. The APR shows the total yearly cost of your loan while the interest rate is the cost of borrowing money from lenders.

The difference between the two lies in the fees they include — the APR includes other loan-related fees, but the interest rate doesn’t. Consider a $10,000 personal loan with a 9% interest and a 5% origination fee. While the interest is only 9%, the APR could reach 12.37%. This means that the overall loan costs more when it considers other charges.

Meanwhile, credit card APRs show how much the lender charges you if you do not pay off your balance in full. Let’s say that your monthly bill is $675. If you only pay $250, you will incur interest on your remaining balance. This goes on until you paid off your remaining balance.

APR vs. APY

Even if APR and APY both measure interests, don’t confuse the two. In simpler terms, APR applies when you borrow money while APY applies when you save money.

APR refers to the total cost of borrowing money, including interest and other charges. However, annual percentage yield (APY) represents the total interest you earn from your savings account or investment. The APY is also sometimes called effective annual rate (EAR).

What is a good APR?

Determining what a good APR is depends on your interest rate and fees. In a loan, your principal loan amount and term, credit score, and overall financial circumstance affect the interest rate you can secure. Generally speaking, the lower the APR is, the better.

With credit cards, your APR rests on your creditworthiness, the prime rate, and the type of credit you’re looking for. This is why there’s no guarantee you’ll get the lowest displayed APR.

To check what a good credit card APR is, compare the rates with the current average credit card APR. According to the Federal Reserve, it currently sits above 20%. Then, consider a card with an APR below the national average. This can help you save on the overall interest you need to pay.

You can also secure a low credit card interest if you have a high credit score. While there are 0% credit card APRs, note that they are often offered to new customers for a limited time. After the introductory period, the APR will revert to a higher rate.

Factors that affect the APR

Lenders and creditors determine the APR you can get. To have an idea of what your APR may be, here are some of the factors that they consider:

Credit score and credit history: One of the biggest determinants of your APR is your creditworthiness. In general, if you have a high or exceptional credit score (above 700), you may qualify for a low APR.
Loan term: Often, shorter loan terms have lower rates because they carry less risk.
Type of credit: Personal loans, car loans, mortgages, and credit cards differ in their APRs. This means that your APR also depends on what kind of loan you’re looking for.
Down payment: If you apply for an auto loan, your down payment also influences your APR. Lenders may offer you a lower APR when you make a larger down payment.

Types of APR

There are different types of credit card and loan APRs that you may encounter:

Purchase APR
This type of APR is the most common APR, and it applies when you make new purchases with your credit card.
Balance transfer APR
This rate applies if you transfer your credit card balance from one card to another.
Cash advance APR
Cash advances refer to any withdrawal you make using your credit card. Commonly, cash advance APRs are higher than those of credit card purchases and balance transfers.
Penalty APR
In some cases, credit card issuers charge penalty APRs if you miss any payment or make late payments.
Introductory APR
Also known as promotional APR, some credit card companies offer introductory periods with low or 0% APR. If you secure a card with 0% APR, this means you won’t have to pay interest during the promotional period.
Fixed APR
A fixed APR is common among installment loans, such as personal loans. With this, your APR remains the same for the loan term.
Variable APR
In contrast, variable APRs increase and decrease with the prime rate and market. For instance, a variable APR is higher when the prime rate climbs.

Bottom line

Understanding the APR and interest rate can help you compare loan options and make better financial decisions. Remember that the APR is just one of the factors that affect your monthly payments. Before signing any agreement, carefully review the terms and fees to find the loan that suits your needs.

Carla Soto

Carla is a skilled copywriter at BestFind with a background in marketing and communications. She specializes in reviewing personal loan and finance products to help readers navigate the complex world of personal finance.