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What Is Annual Percentage Rate (APR)?

June 30, 2022
6
min

The APR takes into account interest rate and any fees a lender may charge for issuing a personal loan or mortgage, or for credit cards, any unpaid balance.

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When borrowing money, an individual will have to pay a lender for the privilege of doing so. A common term the borrower will likely come across is APR, or annual percentage rate, which represents the costs associated with borrowing, plus interest rate and any fees.

APR impacts everything from mortgages to personal loans, and ultimately, increases the repayment amount to the lender.

What is annual percentage rate (APR)?

As the name implies, the annual percentage rate is the amount paid to borrow money on an annual, or yearly, basis. It includes the interest rate and any additional fees the lender may charge for taking out the loan. As a percentage of the loan balance, APR is calculated before taking into account compounding interest, which is the interest accumulated on interest over a period of time.

How does APR work? 

APR is calculated as a percentage of the loan principal. It is charged each year and is included in a borrower’s monthly payments. The types of fees rolled into the APR will depend on the type of loan.

  • Credit cards. Credit cards are considered a type of unsecured loan since they don’t have to be backed by collateral. For credit cards, the APR and interest rates are typically the same. Cardholders are charged an APR if they carry a balance on the credit card. However, if the balance is paid off before the payment due date no APR is charged. APRs may differ depending on whether the card is used for a purchase, balance transfer, or cash advance. APR rates can also vary with late payments, triggering a higher rate known as penalty APR. 
  • Personal loans. Borrowers may be required to pay origination or application fees when taking out a personal loan, which impact APR rates.
  • Mortgages. A mortgage is a type of secured loan because it’s backed by collateral, in this case a house. Mortgages require borrowers to pay closing costs or origination fees, mortgage points, document preparation, and underwriting fees—all included in calculating the APR. That’s typically why there’s a difference between the annual interest rate and APR.  

Knowing the APR for a loan or credit card is important because it can help in making an apple-to-apple comparison of the true cost of borrowing. For instance, when buying a house, comparing the APRs of multiple mortgage pre-qualifications helps the homebuyer understand the fees and interest rate upfront to help determine which loan is best-suited.

Consumer protection laws such as the Truth in Lending Act (TILA) require certain lenders to disclose the APR and other financial charges, as well as the total repayment amount for the loan. Looking at these disclosures can give borrowers a more accurate picture of loan offers to help them make more informed decisions.

What’s the difference between interest rate and APR?

The interest rate is a percentage of the loan a borrower pays for the privilege of borrowing money. The APR, on the other hand, includes the interest rate as well as any fees a lender charges for the loan. In this way, APR is a more accurate reflection of the overall cost of borrowing.

Interest rates and APR are typically interchangeable for credit cards, but that’s not usually the case for other types of loans, which charge borrowers fees on top of the interest rate. 

What are the different types of APR?

An APR can either be fixed or variable.

Fixed APR

Fixed APRs means that the APR won’t change during the lifetime of the loan. Borrowers with this type of APR are most likely making the same monthly payments throughout the duration of the loan, which can be more predictable budget-wise. Personal loans and mortgages usually come with fixed APRs. 

Variable APR

Variable APRs can fluctuate because they are  typically tied to an index rate, such as The Wall Street Journal’s prime rate. That means if the index rate rises, so would the APR. In many cases, a variable APR tends to have lower rates upfront, but can go up over time. Credit cards and mortgages often have variable APRs.

5 factors that affect APR

The following five factors contribute to a loan’s overall APR:

  • Interest rate and fees. This is the interest rate plus any fees associated with borrowing.
  • Credit score and history. Oftentimes, the higher the credit score, the lower the interest rate and APR on a loan or mortgage. Lenders may also look at a borrower’s credit and employment history for any negative remarks such as late payments and bankruptcies to determine loan approval, and in turn, APR rates. 
  • Debt-to-income ratio (DTI). DTI is calculated by taking a borrower’s total monthly debt and dividing it by their gross monthly income. Lenders may require an applicant’s DTI to be lower than a certain percentage to qualify for a loan. 
  • Loan term. Lenders may offer lowered interest rates for shorter loan terms.
  • Type of interest rate. Applicants for variable rate loans may be offered a lower APR initially, but that could change and increase over time. 

How is APR calculated?

The APR is calculated by multiplying the periodic interest rate—the annual interest rate divided by how often the borrower makes payments—by the number of pay periods. Since lenders are required to disclose the APR, consumers usually don’t have to calculate the APR themselves. 

The formula for calculating the APR is: 

[(fees and interest over lifetime of loan / loan amount) / days in loan term] x 365 x 100 = APR

For example, let’s say an individual borrows $10,000 in a one-year personal loan. Over the 365-day loan term, there’s $500 in interest and $150 in fees from the lender.

So, to arrive at the APR:

  • Add the interest and fees paid ($650)
  • Divide that number by the loan amount ($650/$10,000=0.065)
  • Take the resulting number and divide it by the loan term (0.065/365 = 0.000178082192)
  • Multiply the result by 365 (0.000178082 x 365 = 0.065)
  • Multiply that number by 100 (0.065 x 100 = 6.5) 

In this scenario, the APR is 6.5%. 

The bottom line

The APR takes into account interest rate and any fees a lender may charge for issuing a personal loan or mortgage, or for credit cards, any unpaid balance. An APR can come in different forms including fixed and variable, depending on lender and type of financial product. Understanding the APR can be helpful when comparing multiple loans, as it can give a more accurate picture of the total cost of the loan than interest rate alone.

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