Annual Percentage Rate: What It Is, How It Works and What to Avoid
The Annual Percentage Rate (APR) is the approximate yearly cost of borrowing money from a financial institution. It reflects the interest and/or fees assessed in conjunction with your balance and serves as a basis for choosing between similar financial products (e.g. between multiple credit card offers or mortgages).
Many different types of financial products have APRs, including credit cards, auto loans, mortgages and personal loans. As you’ll see below, APRs function a bit differently for open-ended financial agreements such as credit cards than they do with closed-ended agreements like mortgages.
Whatever type of financial product you have, you should be able to find your APR listed on your original loan agreement as well as the periodic statements that you receive. Understanding what your APR is and how it functions is extremely important to managing your debt and your repayment options strategically. This guide will help you do just that.
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 if you pay your bill in full every month and thereby maintain your grace period. This gives you at least 21 days from when your statement becomes available to pay your bill before the payment is considered late.
Credit card interest is assessed on a daily basis. This means that a credit card company will determine how much to charge you on a given day by multiplying the balance at the end of that day by your APR/365. These interest charges will then become part of your balance the next day and will themselves incur interest. The process of interest incurring interest is known as compounding.
For example, let’s say you entered the month with a $350 balance remaining on an account with a 15% APR. Your end-of-day balance after the first day would be $350. Assuming you made no purchases or payments, your balance at the end of the second day would be that $350, plus $0.14 in interest that accrued on the previous day’s balance ($350 *(0.15/365)). This process would then repeat every day for the rest of the billing period.
A quick way to determine your overall interest charges for a given month is to use the average daily balance method. This entails first adding up all of the end-of-day balances for each day in the billing period and dividing by the number of days in the billing period to get the average daily balance. You then multiply the average daily balance by the daily periodic rate (APR/365), which you then multiply by the number of days in the billing period. That’s it (see below for formulas).
By the way, if all of this seems confusing, don’t worry, it’s because it is confusing! You’re not alone.
Average Daily Balance = Total Daily Balances (Principal + Previous Day’s Interest + New Purchases) / Number of Days in the Billing Cycle
Daily Periodic Rate = APR /365
Interest Charges = (Average Daily Balance * Daily Periodic Rate) * Number of Days in the Billing Cycle
Types of Interest Rates:
It is important to note that every credit card – with the obvious 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, a balance transfer APR, a cash advance APR, and potentially a penalty APR as well. It might 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 (e.g. 6-18 months).
Card APRs can also differ in terms of whether they are fixed or variable. Variable rates change in accordance with the fluctuations of a certain index rate, such as the Prime Rate or the LIBOR Rate, while fixed rates do not.
You can read more about all of these different types of rates in our article about Credit Card Interest Rates.
The APR on a loan – a mortgage, for example – indicates the total yearly cost associated with borrowing money from a financial institution, expressed as a percentage of the amount being borrowed. Unlike with credit cards, a loan’s APR reflects more than just the interest payments that must be made over time. It also includes certain fees, such as processing and underwriting fees, private mortgage insurance and mortgage points.
Let’s say, for example, that you are being quoted an APR of 3.5%. This would mean that if all of the interest and fees associated with your loan were to be added up and spread evenly across the life of the loan, the annual cost would amount to 3.5% of the amount being borrowed.
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 provide the basis for a direct apples-to-apples comparison because: 1) most people do not keep their mortgages for the entire life of the loan, which skews the effective finance charges they pay; and 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 inquire as to what the APR on a prospective loan entails in order to get an accurate sense of whether it is a good deal or not.
It is also important to note that lenders are required to list both the APR and the interest rate associated with a loan on all marketing materials, at least in the case of mortgages. This will give you a better sense of how much of your APR is attributable to fees.
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.
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 do, the theoretical and practical APRs will be equal. However, 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 would be effectively front-loaded, increasing the effective APR relative to the nominal one. You’ll pay these fees upfront 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.
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.
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