What Is APR? A Guide To Annual Percentage Rates

Updated: May 15, 2019 

mike-pearson

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:

lending-club-apr

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:

apr-credit-karma

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.

Fixed APR

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.

Variable APR

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:

  • Purchase APR. The purchase APR is probably the first percentage you’ll see on your terms and agreements. This is the rate applied to all your purchases.
  • Introductory APR. You’ll often see credit card offers with low introductory APRs, with some even offering 0%. Usually, these rates apply to your first year of use and then go up significantly after that. It’s important to understand that any balance left on your card the day after the intro offer is up will be charged the new rate.
  • Cash advance APR. The APR for cash withdrawals is almost always higher than your purchase APR. In addition, there are usually other fees involved. Your credit card company may have flat cash advance fees and you could be charged ATM fees.
  • Balance transfer APR. When you transfer a balance from one card to the next, you’ll probably be charged the same APR for it as you are for purchases. The difference is that there is no grace period and you’re usually assessed interest the moment it is transferred.

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.

Loan length

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

  • Shop around. The most obvious way to get a low APR is to shop around with different companies. Credit cards, especially, have their rates listed online, so it’s easy to compare. You can start by looking for cards that offer a 0% introductory APR. Just be sure to pay attention to what it will increase to once you pass the intro period. Also, look for fees that could sour an otherwise sweet deal.
  • Use a credit union. If you qualify for membership with a local credit union, you can almost always get better interest rates for any type of loan. It’s also sometimes easier to qualify for lines of credit through them than with major banks.
  • Improve your credit score. The best way to ensure you get the best rates on any loan is to improve your credit score. A credit score can range from 300-850, with anything above 670 considered good. People with higher scores are considered low credit risks, therefore they get the best deals. (If you need help improving your credit score, a credit repair company like Lexington Law can definitely help).

Final thoughts

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-pearson

Mike Pearson

Mike is a recognized credit expert and founder of Credit Takeoff. His credit advice has been featured in Investopedia, CreditCards.com, Bankrate, Huffpost, The Simple Dollar, Reader's Digest, LendingTree, and Quickbooks. Read more.

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