What Is APR? A Guide To Annual Percentage Rates
APR is a lending acronym that stands for annual percentage rate.
But, it’s a lot more than just the interest rate you’re charged for your loan.
APR is actually calculated using the sum of all the interest and fees you’ll be charged annually.
In other words, it’s simply how much it costs to borrow money.
How does APR work?
Some people think their APR and interest rates are the same thing, but it’s important to know that they’re not, or else you’ll likely be confused by the terms on your loan documents.
A good example of the differences between APR and yearly interest rate can be found here on Lending Club’s website:
As you can see, the APR is a little higher than the annual interest rate: that’s because the origination fee is added to the interest rate, and then that amount is calculated to figure out what percentage of your principal is actually interest and fees.
Sound confusing? It certainly can be!
And to add to that confusion is the fact that some loans only charge interest on the amount of principal at any given time and others charge based on the total balance.
But either way, the amount you pay in interest should decrease a little each month because you are paying down your loan.
To even further add to the confusion, some loans also have fixed rate interest, while others have variable rate.
This just means you either get one interest rate for the entire length of your loan or your rate will fluctuate with the market.
A good example of loans with variable rates are credit cards. (We’ll go into this in more detail later).
How to calculate APR
APR is calculated using a very specific formula:
So, to use a simple example using the formula above (via Credit Karma), let’s say you took out a loan for $1,000 with a $50 fee and 10% interest, and the length of the loan is 3 months.
If we plug these numbers into the formula, the first step not actually shown here is to figure out what your interest paid over the life of the loan will be.
And if you remember anything from junior high math class, the formula for interest is:
Interest = principal x rate x time
So, in this scenario, interest = $1,000 x 10% x 2 (years) = $200.
This is the total amount of interest that will be paid on this loan.
Now, we can plug it all into our formula.
1. Fees + Interest paid over the life of the loan is $50 + $200 = $250.
2. $250 ÷ $1,000 = .25
3. Previous total ÷ number of days in loan term is .25 ÷ 730 = .0003424658
4. Multiplied by 365: .125
5. Multiplied by 100 to get your APR of 12.5%
Fixed vs variable APR
Like I mentioned earlier, all loans have either variable or fixed APRs.
A fixed rate APR does not usually fluctuate over time. (I say “usually” because this doesn’t necessarily mean the rate will never change—it just means the lender has to notify you in advance if it is going to).
But you might be wondering why call it a fixed rate, then?
It’s actually simpler than it sounds.
The “fixed” rate just means it doesn’t fluctuate with changes to an index (like the prime Wall Street Journal published rate), but it doesn’t prevent the lender from every re-evaluating their charges.
Credit cards are the best example of variable rate credit lines, which do fluctuate with a prime interest rate index.
And depending on your terms, these rates could change multiple times a year.
But it's worth noting, variable rate loans are subject to the same Truth in Lending policies as others, so they do have to inform you in advance.
Other types of APR
Aside from fixed and variable APR, there are also other types of APRs, particularly when using a credit card.
This is because these types of companies attach different fees to different types of transactions.
Here are some common types:
Simple vs compound interest
Just in case you were starting to get clear on all the aspects of an APR, here’s one more twist.
Remember when I mentioned earlier that some loans calculate interest based just on your principal while others do so based on the entire balance?
Well, the correct terminology for this is simple or compound interest, respectively.
Here’s a little more explanation:
Simple interest is calculated with this formula:
principal amount x annual interest rate x term (in years)
You can easily figure out what your total interest will be from this formula. That is, provided it’s a fixed APR loan, which most simple interest loans are.
Compound interest, on the other hand, accrues over time and you’ll pay interest on the accumulated amount rather than just the principal.
The formula for this is:
principal amount x (1 + rate)time - principal amount
For example, say you take out a $1,000 loan at 5% for two years.
Your formula would be 1,000 x (1 + .05)2 - 1,000.
The amount of interest you would end up paying on this loan would be $102.50. (This is also provided that you have a fixed interest loan rather than variable).
The details for variable rate loans, as you can imagine, can get very complicated.
But you can use online calculators to help you get a better understanding.
What impacts your interest rate?
If you’ve ever applied for a loan, you’ve probably figured out that not all interest rates are the same—this is true of different industries and companies, but it’s also true between applicants.
Your credit score
Most major or store credit cards offer one rate for its product, but each company may have several products to accommodate people with different credit score ranges.
For example, most of Discover’s credit cards come with 14.24-25.24% variable interest rates.
But their credit-building secured card starts at 25.24%.
In other words, the better your credit, the lower your rates. And that’s one of the only factors you have moderate control over.
The other factor you might be able to control is the length of your loan.
Choosing a shorter loan term may mean bigger payments, but it will ultimately mean paying less for the loan. But there are some factors that are simply out of your control.
For one, you can’t control supply and demand.
As demand for money rises, so does the cost of getting it.
So, in a poor economy, when people are not depositing much money in their accounts or are pulling most of it out, the demand for money rises. This means any loan you get will cost more and come with a higher interest rate.
Federal reserves rate and inflation
Other factors that affect interest rates are the federal reserves rate and inflation.
The federal funds rate is the fluctuating amount charged between financial institutions for short-term loans, and it’s determined by the US Federal Reserve.
They do this to help keep the economy balanced and they can raise or lower the rate whenever needed to encourage or discourage more borrowing.
3 tips for getting the lowest APR
It’s important for you to know what an APR is and how it is calculated so you know how much your credit is costing you.
Of course, with different types of loans and APRs, terms are subject to change.
But it’s up to your lending institution to clearly disclose all the details.
And as a smart consumer, keep in mind there are things you can do to keep these costs as low as possible.
About the Author
Mike is a recognized credit expert and founder of Credit Takeoff. His credit advice has been featured in CNBC, Investopedia, CreditCards.com, Bankrate, Huffpost, The Simple Dollar, Reader's Digest, LendingTree, and Quickbooks. Read more.