If you ever take out a loan, you need to understand what your annual percentage rate is. APR is the average rate of interest you’ll pay annually over the life of your loan. APR plays a vital role in many consumer products, such as credit cards, auto loans and mortgage loans. Here’s a look at the ins and outs of APR so you can answer the basic finance question, “What does APR mean?”
How Does APR Work?
A loan issuer — typically a bank — is responsible for setting an APR. Usually, an APR is based on the U.S. prime rate, which is the best rate that lenders offer their most reliable customers. Banks will then charge a margin of profit on top of the prime rate.
Typically, the higher your credit score, the lower APR you will get. For credit cards, banks will use either a daily or a monthly periodic rate. Multiplying a daily periodic rate by 365 will give you the APR; for monthly periodic rates, multiply by 12 to get the APR.
APR vs. APY
APR is different from annual percentage yield in that APY factors in the effect of compounding. For example, a 1.32 percent annual interest rate that is compounded monthly carries an APR of 1.329 percent. This can work both ways. If you’re paying interest on a loan, it can work to your detriment. If you’re earning interest on a CD or savings account, however, it works to your benefit.
APR vs. Interest Rate
APRs and interest rates are related but have slightly different calculations. The interest rate on a loan is the current rate of interest that you pay, whereas APR factors in the total cost of your loan. For example, when referring to mortgage rates, your APR will include both the interest rate you pay and points, fees, and other charges, usually making your APR higher than your stated interest rate.
Types of APRs
For credit cards, you might be subject to different types of APR. The standard APR is the purchase APR, which applies to any purchases you put on the card and don’t pay off before the grace period ends. Some cards offer an intro APR, which is an introductory promotional rate — such as 0 percent — that expires after a certain time period.
A penalty APR might come into play if you fail to pay at least your minimum balance on time. A cash advance APR might apply to balances that you withdraw as cash, such as from an ATM. Cash advance APRs are often higher than standard or introductory rates. In order to best understand why you’re being charged the interest rate you are, it’s important to learn how to calculate APR.
APR and the Law
Certain consumer protections are built into credit card APRs. For starters, lenders can’t change your APR during the first 12 months unless you violate the card’s terms and conditions or you’re under a promotional rate. Also, in general, lenders must inform you 45 days in advance of any change in your APR.
Calculating your APR is important so that you can understand the full cost of your loan. Whether it’s a home mortgage, auto loan or personal loan, APR is a critical factor to your budget and financial health.