What Is APR? How Can You Use It to Compare Loans?
If you’ve ever had a credit card, car loan, or mortgage, you know the finance world uses the term APR to describe a loan’s annual percentage rate. However, it can be tricky to understand how that number translates to the amount you’ll actually pay for credit or financing. In this guide, I’ll demystify APR to help you make smart borrowing decisions that support a healthy financial future.
What Is APR?
According to the Consumer Financial Protection Agency, the APR is the price you pay when you take out a loan. APR expresses the cost of a loan in a 12-month period as a percentage. Federal law requires banks and lenders to tell you the APR of a credit card or loan when you borrow money. You will find this information on your loan paperwork in a table called the Schumer box.
How Does APR Work?
When you borrow money or make purchases using a credit card, the bank or lender charges interest. To determine APR, the bank adds its own profit margin to the U.S. Prime Rate. Set by the Federal Open Market Committee, the prime rate is the lowest available interest rate for borrowers, which generally ranges between 3 and 6%.
If you carry a balance on a credit card from one month to the next, the credit card company multiplies that balance by the APR and adds that amount of interest on your next month’s bill. Let’s say I have a $300 balance on my credit card with a 20% APR. If I do the math, I get:
$300 x .2 = $60
The bank will charge $60 in interest for August. If I carry that $360 balance through September, the bank will charge monthly interest of $72 ($360 x .2), bringing my October balance to $432.
This concept, called compound interest, helps explain why many people have difficulty getting out of credit card debt when they accumulate a balance. Most banks and credit card companies do not charge interest on purchases during a grace period, usually 25 days. If you pay off the purchase during that grace period, you avoid the cost of compound interest.
How Do You Calculate APR?
You can figure out how much interest you will pay on a loan by understanding how the bank calculates your APR payment. When the lender compounds interest daily, they divide the APR by 365 (days in a year) to get the daily periodic rate (DPR).
Next, they multiply DPR by the number of days in the billing cycle (usually 30 or 31 for an account that has monthly billing). Finally, this result multiplied by the balance provides your total interest for that billing period.
Some loans compound interest every day, while others charge monthly interest. Let’s look at how daily compounding affects the cost of a loan. In this example, I take out an auto loan for $10,000 that charges daily compound interest of $1 (0.0001%) per day. On the second day of the loan, I owe interest on $10,001 rather than $10,000, which equals $1.0001. While the extra interest represents just a fraction of a cent, it grows over time to create profit for the lender.
How Can You Use APR to Compare Loans?
Knowing the APR of a loan can help you compare it to other loan offers. This helps you determine the best choice for your financial needs.
Credit card companies and lenders typically have a range of available APRs depending on the borrower’s financial profile. If you have steady income and a good credit score, you will qualify for a lower APR than the rate offered to a borrower with poor credit or a limited work history.
When evaluating the APR on a loan offer, consider these factors that affect the available rates:
- Your credit history
- The current prime interest rate
- Competing rates for similar loans
Interest rates for credit cards vary dramatically by factors such as bank and credit history. The average APR ranges from about 13.33% to 29.99%. With a loan comparison tool like LendingTree, you can review available interest rates and other terms side-by-side.
If a loan offers a low introductory APR, read the fine print to see how much your interest rate will rise after the first few months to get a true picture of cost. The card agreement will also indicate when the lender can change the APR. Usually, banks can raise your interest rate for any reason, including missed payments, an increase in the Prime Rate, or a dip in your credit score. However, they must provide 45 days written notice before doing so.
Different Types of APR
Lenders use several different types of APR, so double-check the fine print before you make a borrowing decision. Common forms of APR include:
- Introductory APR, also called promotional APR, which refers to a lower interest rate during the first few months of loan or credit card payments
- Purchase APR, typically the standard rate that applies to purchases with a line of credit. Credit card companies begin charging interest on purchases at the start of the next billing cycle.
- Cash advance APR, usually higher than the purchase APR, applies to cash advances. With a cash advance, you begin accruing interest right away rather than in the next billing cycle as with a purchase.
- Penalty APR, a higher APR imposed by the lender because of late payments or other account issues. The penalty APR is often 29.99%, the highest amount allowed by law.
- Effective APR, which includes all interest and fees as well as compound interest
Loans and credit lines can also have either a fixed or variable APR. The variable APR changes based on factors like the federal prime interest rate or changes to your credit history. A fixed APR stays the same until you repay the loan and close the account.
What’s the Difference between APR and Interest Rate?
Unlike the simple interest rate, which indicates only what you’ll pay in interest on the loan, the APR also includes common fees such as:
- Document fees for contracts and other legal paperwork
- Underwriting fees that cover the cost of evaluating your credit and making a loan decision
- Processing fees, which cover miscellaneous expenses
As a result, comparing loans using only the simple interest rate and not the APR does not provide a true picture of the cost of borrowing from that lender. You can see how this works by comparing two sample mortgage loans, both for a principal balance of $300,000
- Lender #1 charges an interest rate of 3%, with fees that push the APR to 4%. Based on this information, you would pay $120,000 in interest and fees over the life of the loan.
- Lender #2 quoted an interest rate of 3.5% but fees of just 0.25%, increasing the APR to 3.75%. You would pay $112,500 in interest and fees over the life of the mortgage, making this the smarter financial option despite the higher stated interest rate.
What’s the Difference between APR and APY?
I think of annual percentage yield (APY) as the reverse of APR. Instead of paying interest to borrow money, APY is the interest you earn on money you hold in a savings account or retirement fund.
While APR increases the amount you owe through compound interest if you carry a balance from one month to the next, APY allows you to take advantage of compound interest by earning a percentage of both your contributions and the interest earnings from previous months. You may also hear APY called the effective annual rate (EAR).
How Can You Qualify for a Better APR?
Improving your credit score lowers the risk of lending you money. As a result, you become eligible for lower-APR loans and credit cards. Take these steps to get on the path to more attractive credit offers:
- Pay off as much of your balance as possible each month. Most financial experts recommend using no more than 30% of your available credit, or about $2,000 if you have a credit card with a $6,000 limit.
- Make timely payments. Doing so builds a solid credit history and allows you to avoid costly penalties. Sign up for automatic payments if you have trouble remembering to clear your balance on time.
- Avoid applying for credit you don’t need. Too many inquiries can be a red flag for lenders, especially in a short time period.
- Check your credit report once a year. You can obtain a free copy annually from each of the three credit bureaus (Equifax, TransUnion, and Experian). Dispute incorrect information that may be negatively affecting your FICO score.
If you are shopping for a loan or credit card and aren’t sure whether a particular offer makes sense for your financial situation, refer back to this guide to clearly assess its merits based on APR and other factors. Knowledge about financial concepts can eventually help you qualify for more favorable interest rates, lowering the expense of borrowing the money you need to meet your goals.