What Is an APR and How Does It Work?

An annual percentage rate (APR) is the estimated yearly cost of borrowing money, expressed as a percentage of the total amount borrowed. The APR includes the interest charges that will apply to a balance, as well as related fees in some cases.

Key Things to Know About APRs

• Many different types of financial products have APRs, including credit cards, auto loans, mortgages, student loans and personal loans.
• Annual percentage rates serve as a basis for choosing between similar financial products (e.g., between multiple credit card offers or mortgages).
• You should be able to find any financial product’s APR listed on the original borrower agreement, as well as on the periodic statements that you receive.

Some credit cards even offer an introductory APR of 0%. You can check them out using the link below, and then continue reading to learn more about APRs and how they work.

Best 0% APR Credit Cards

How Does an APR Work?

A financial product’s APR, along with the amount of money loaned to the borrower, determines the amount of interest that the borrower owes with each payment they make. However, there are nuances to how an APR works based on whether you borrow using a credit card or a loan.

How a Credit Card APR Works

The APR on a credit card dictates the interest that you will pay when carrying a balance from month to month. You will not incur interest on purchases if you pay your bill in full every month because credit cards have a 21- to 25-day grace period between when you receive your bill and your due date.

When you do carry a balance, credit card interest gets assessed on a daily basis. Every day, you owe interest not just on your principal balance, but also on the interest you’ve already accrued. We’ll explain more about that process in the section on interest calculations below.

How a Loan APR Works

Unlike with credit cards, a loan’s APR usually reflects more than just the interest payments that must be made over time. It also includes certain fees, such as origination fees on personal loans as well as some processing and underwriting fees on mortgages. Essentially, loan providers add up all the interest and at least some of the fees associated with a loan, and they spread them out over the life of the loan. Then, they use that to quote you an APR.

You typically pay loans back with equal monthly installments, so often times the interest you pay won’t vary from month to month. But on loans that use what’s called “amortized interest,” the amount of the payment stays the same but the portion of each payment that goes toward your principal or your interest changes. We’ll go into that in more detail below.

How to Calculate an APR

You’ll never really need to calculate an APR yourself because it’ll be listed on your credit card or loan agreement, but it’s still worth knowing how lenders do their math. Your APR is calculated differently based on whether you have a loan or a credit card.

For a loan, the steps to calculate the APR are:

1. Add up the sum of the interest charges and fees.
2. Divide that by the amount borrowed.
3. Divide the result by the number of days in the loan term.
4. Multiply by 365 to get the annual rate.
5. Multiply by 100 to get the rate in the form of a percentage.

For a credit card, the APR is simply the product of three numbers:

• The “daily rate,” which is the percentage of interest charged each day (the APR / 365)
• The average daily balance, which is the balance the card had every day of the billing cycle added up, divided by the number of days in the billing cycle
• The number of days per billing cycle

In other words, daily rate * average daily balance * number of days in the billing cycle = APR.

You can learn more about how an APR is calculated here on WalletHub.

Now that you know the basics of how APRs themselves are calculated, let’s take a look at how lenders use those APRs to calculate interest.

Formulas and Examples for Interest Rate Calculations

Credit Card Interest Formulas

Average Daily Balance = total daily balances / number of days in the billing cycle

Daily Rate = APR / 365 (Note: Some issuers may divide by 360 instead)

Interest Charges = average daily balance * daily rate * number of days in the billing cycle

Note: “total daily balances” include the principal + previous days’ interest + new purchases

Credit Card Interest Calculation Example

Let’s assume the card’s total daily balances equal $5,000, there are 30 days in the billing cycle, and the card’s APR is 15%.

Average Daily Balance = $5,000 / 30 days = $166.67

Daily Periodic Rate = 15% / 365 = 0.04%

Interest Charges = $166.67 * 0.0004 * 30 = $2.00 for the whole billing period

You can learn more about how credit card interest is calculated here on WalletHub. You can also use WalletHub’s free credit card calculator to crunch the numbers for yourself.

Formulas for Calculating Interest on Loans

The calculation of interest is different depending on whether the loan uses simple or amortized interest. With simple interest, your monthly payment is the same each month, and the total amount of interest you’ll owe over the lifetime of the loan is divided equally across your payments. In other words, each payment puts the same amount of money toward your principal (the original amount borrowed) and the interest.

Simple Interest Formula

Interest for each month = loan principal * APR * loan term in years

With amortized interest, your monthly payment is still the same each month, but the share of each payment that goes toward the principal or toward interest changes. As you pay off more and more of your balance, the portion of your monthly payments that goes toward the principal grows, while the portion that goes toward interest shrinks.

Amortized Interest Formula

Interest for any given month = (APR / number of payments per year) * remaining loan balance

But you really don’t need to do the math yourself. A loan calculator can easily do the work for you.

Loan Interest Calculation Example

Loan APR: 10%

Loan Amount: $10,000

Payoff Period: 5 years

You can use WalletHub’s personal loan calculator to try this out for yourself.

Types of Interest Rates

It’s important to note that every credit card – with the exception of charge cards – has a few different types of APRs, which are distinguished from one another based on the types of transactions they apply to as well as the passage of time. For instance, a single credit card will have a:

• Purchase APR
• Balance transfer APR
• Cash advance APR
• Penalty APR

A credit card may also have an introductory APR for purchases and/or balance transfers that is lower than the regular rate but only lasts for a certain period of time (typically 6-24 months).

Card APRs can also differ in terms of whether they are fixed or variable. Variable APRs change based on fluctuations of a certain index rate, such as the Prime Rate at which banks lend to their most creditworthy customers. Fixed APRs do not change.

You can read more about all of these different types of rates in our article about Credit Card Interest Rates.

Types of Interest Rates

It’s important to note that every credit card – with the exception of charge cards – has a few different types of APRs, which are distinguished from one another based on the types of transactions they apply to as well as the passage of time. For instance, a single credit card will have a:

• Purchase APR
• Balance transfer APR
• Cash advance APR
• Penalty APR

A credit card may also have an introductory APR for purchases and/or balance transfers that is lower than the regular rate but only lasts for a certain period of time (typically 6-24 months).

Card APRs can also differ in terms of whether they are fixed or variable. Variable APRs change based on fluctuations of a certain index rate, such as the Prime Rate at which banks lend to their most creditworthy customers. Fixed APRs do not change.

You can read more about all of these different types of rates in our article about Credit Card Interest Rates.

Key Things to Remember When Comparing Loan APRs

Loan APRs are designed to simplify direct comparison of loan offers, making it easy to contrast the cost of borrowing money from one institution to the next. At least that’s how things work in theory. In a practical sense, however, loan APRs do not always provide the basis for a direct apples-to-apples comparison for two reasons:

1. When it comes to mortgages, most people do not keep their mortgage for the entire life of the loan, which skews the effective finance charges they pay.
2. The types of fees that are included in an APR are not standardized. One lender might include five different fees, for example, while another could incorporate 10. It is therefore very important that you ask what the APR on a prospective loan includes in order to get an accurate sense of whether it’s a good deal or not.

It is also important to note that when it comes to mortgages, lenders are required to list both the APR and the interest rate associated with the mortgage on all marketing materials. This will give you a better sense of how much of your APR comes from fees.

Types of APRs

We know that APRs differ by the type of financial product. For example, the APR on a loan is a bit different than the APR on a credit card because loan APRs often factor in fees. How high APRs get differ by product, too.

A single financial product can also have more than one type of APR. For instance, a credit card can have a purchase APR, balance transfer APR, cash advance APR, penalty APR, and introductory APR. It’s important to understand how each type works and when it applies so you can take steps to minimize your costs and maximize your savings.

Purchase APR

The purchase APR is the most common interest rate credit card users will deal with. It applies to balances that you carry from month to month. But you’ll never actually owe any interest if you always pay your balance in full by your due date, assuming your card has a grace period.

Introductory APR

An introductory APR is a promotional rate – often 0% – given to new customers for a certain period of time. With a credit card, an introductory APR may apply to purchases or balance transfers.

Balance Transfer APR

A balance transfer APR is a type of credit card interest rate that applies to any balance moved to the card from an account with another creditor. For example, you might move the balance of your auto loan onto a credit card. Many balance transfer cards will give you an introductory rate, usually 0%, for a certain number of months. After that, the regular APR takes effect and applies to any remaining balance.

Penalty APR

The penalty APR, or default APR, is one type of interest rate you definitely don’t want to encounter. It is an elevated rate put into place because of account misuse. A credit card issuer can apply this APR to any new purchases you make as soon as you’ve missed a single payment. They can apply it to your existing balance once you become at least 60-days delinquent, meaning you’ve missed two payments. And it will take six months of on-time payments before your issuer is required to revert the rate on existing balances.

Cash Advance APR

A cash advance APR is a credit card interest rate that applies to money you withdraw from an ATM or spend via a so-called convenience check. This rate is typically higher than the card’s regular APR, and it applies right away after a transaction.

Learn more about the different types of credit card interest rates, as well as personal loan rates and even the highest savings account rates.

APR vs. Interest Rate

APR and interest rate are two very similar terms that have slightly different practical definitions. The relationship between the two terms also differs depending on whether you are talking about a credit card or a loan.

When it comes to credit cards, the actual rate at which you accrue interest will be your APR divided by 365 (days in a year), since credit card interest is assessed on a daily basis. For instance, if your APR is 15%, you’ll be charged a 0.041% interest rate on your outstanding daily balance.

With loans, things work the other way around. Rather than your APR being set and thereby dictating your interest rate, your interest rate and fees will first be determined and will combine to create your APR. Mortgage lenders are required to disclose both a loan’s APR and its interest rate in order to give borrowers a clear sense of how all of the expenses associated with the loan contribute to its overall cost.

APR vs. EAPR

“EAPR” stands for “effective annual percentage rate.” To understand what that means, you first have to wrap your head around the fact that APRs often function differently in theory and in practice. This phenomenon is most pronounced with credit cards, as the APR cannot take into account the impact of daily compounding (accruing interest on interest).

For most loans, on the other hand, whether or not there is a difference between the theoretical and practical APRs depends on if you keep the loan for its full term:

• If you keep the loan for its full term, the theoretical and practical APRs will be equal.
• If you only keep your loan for a fraction of the term – as would be the case if you sold your home a few years into a mortgage, for example – then the fees that are spread over the life of the loan for the purpose of creating the APR are front-loaded. That increases the effective APR relative to the nominal one.
• You’ll pay these fees in both cases, but since the APR reflects the annual cost of borrowing money over the life of the loan, reducing your loan term while keeping the fees the same increases the annual rate.

With that being said, let’s explore the difference between APR and EAPR for credit cards in a bit more detail because it is slightly more complicated:

Nominal APR (or simply APR)

Your nominal annual percentage rate, which is what is printed on credit card offers and monthly statements, reflects the cost of carrying a credit card balance in the absence of compounding. Supposing your credit card has a 25% APR and you carry a $100 balance for a year, you would owe $125 by year’s end. However, the actual amount of interest (EAPR) you would pay will be more.

Effective APR (also called EAPR or simply EAR)

Your effective annual percentage rate, or simply effective annual rate, reflects the true annual cost of carrying a credit card balance. Because credit card companies calculate interest on a daily basis, it compounds over time. Again, that means the interest you incur today will apply to your balance and the interest you accrued yesterday and the day before that, and so on.

As a result, your EAPR will always end up being higher than the advertised nominal APR. The higher your nominal APR, the greater the differential (or disparity) will be between your APR and your EAPR.

For instance, let’s assume again that your credit card has a 25% APR, and you carry a $100 balance for a year. When that interest is compounded daily, it would translate to an EAPR of 28.39%, or 13.6% higher than the nominal APR in relative terms. Compound interest applied, your balance would grow to about $128.39 by year’s end.

APR vs. APY

You may have heard the term APY (Annual Percentage Yield). Be careful not to confuse APY with APR. Here’s an easy way to distinguish between the two: APR is interest that you pay on a loan, whereas APY is interest you would earn on an investment. Also, APR is annualized simple interest. APY is calculated the same way as the EAPR and considers compounding.

What Affects Your APR?

Credit card companies and loan providers determine their APRs based on creditworthiness – or how much risk you pose as a borrower – as well as broader factors, like the health of the economy. Creditworthiness is based on criteria such as your credit history, income, and debt. Other considerations include your age, monthly housing payments, and employment status.

APRs can also be fixed or variable. If you have a variable APR, your rate could go up or down based on changes in the broader economy.

Learn more about how credit card companies determine their APRs.

How Do I Find My APR?

You can find the APR for a credit card account by looking at your cardmember agreement or monthly statements. This information should be easily accessible through your online account.

Similarly, with a loan, your APR should be readily available via your loan agreement, account statements and the lender’s website. You could always call customer service, too.

Learn more about finding your credit card interest rate.

How to Avoid Interest Charges

There are several different strategies you can use to avoid interest. Each one only works in certain situations.

Avoid Borrowing

The best way to avoid interest charges is simply not to borrow. If you don’t have any debt, there’s nothing to pay interest on. That’s easier said than done, though. Sometimes, you might have no choice but to borrow money.

Finance Your Expense With a 0% Intro APR

Try to opportunistically take advantage of 0% financing deals. You might be able to get 0% financing on a car, a big purchase from a major retailer, or any purchase made with a 0% introductory APR credit card.

However, you’ll need good credit or better to get the best deals, and retailer financing offers often include a dangerous feature known as deferred interest. With deferred interest, if you don’t pay the balance in full by the end of the 0% APR period, you retroactively owe all the interest you would have owed starting from the date of purchase.

Utilize a Credit Card’s Grace Period

Fortunately, you won’t have to pay interest on everyday purchases made with a credit card that has a grace period, as most credit cards do. A credit card’s grace period is the 21-25 days between the end of a billing cycle and your monthly due date, during which interest will not accrue. To benefit from the grace period, you need to pay in full each month.

Learn more about how to avoid credit card interest charges.

Ask the Experts

We asked a panel of experts to share their advice and insight with APR. Click on the experts’ profiles to read their bios and responses to the following key questions:

1. What is the biggest misconception people have about annual percentage rates?
2. How should consumers use APRs to compare financial products?
3. Do you think the average adult knows what APR stands for? Do you think they know how annual percentage rates work?