APR is the total rate of interest you’ll pay annually over the life of a loan. It plays a vital role in many consumer financial products, such as credit cards, auto loans and mortgage loans.
What Is APR and How Does It Work?
The annual percentage rate represents how much it costs to borrow money. APR is based on the interest rate and all fees charged by the lender. It is expressed as a percentage.
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 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 use either a daily or a monthly periodic rate. Dividing the APR by 365 gives you the daily periodic rate. Dividing the APR by 12 gives you the monthly periodic rate. The lender adds the periodic accrual to your balance.
What Is the Difference Between APRs and Interest Rates?
APRs and interest rates are related but have slightly different calculations. The interest rate refers to the amount of money the lender charges you for the loan. APR factors in the total cost of the loan.
Say, for example, you take out a one-year loan for $1,000 at a 5% interest rate. You will repay the lender the original $1,000 you borrowed plus an additional $50 in interest.
However, most loans have additional fees and charges. There may be origination fees, monthly maintenance fees or check processing fees. Factoring in these fees increases the total cost of borrowing money.
Using credit cards and taking out loans cost money. When you take a cash advance of $1,000 on a credit card, for example, the card issuer might charge an interest rate of 20%. If the card issuer also charges a cash advance fee of 2%, the APR — the actual cost of borrowing the money — is 22%.
If there are no other fees associated with borrowing money, there is no difference between the interest rate and APR. In most cases, APR is higher than the stated interest rate for an account.
Difference Between Types of APRs
If you take a close look at your credit card disclosure statement, you may notice more than one APR listed. That’s because there are different types of APRs — even for the same account. Here’s a quick look at them:
Types of APRs
- Purchase APR: Applied to purchases you make with the credit card. You pay this APR if you don’t pay the balance within the grace period.
- Cash advance APR: Applied when you withdraw cash using the credit card. This tends to be higher than the purchase APR.
- Penalty APR: The highest APR. It applies to certain balances when you do something like miss a payment or exceed your credit limit.
- Introductory APR: Often the lowest APR. It’s typically used as a promotion, such as a temporary 0% APR for balance transfers.
What Is a Good APR?
A good APR is one that’s lower than the average interest rate. These APRs are usually reserved for customers with the highest credit scores.
APR is only one factor to consider when choosing a credit card or loan. It’s important to shop around and compare all of the terms of each product you’re considering. Look at the following features:
- Annual fee
- Cash advance fee
- Finance charges
- Grace period
- Late payment fee
- Rewards program
- Security features
In most cases, you don’t have to calculate APR manually. There are plenty of online calculators available that will do the work for you.
This article has been updated with additional reporting since its original publication.