By Kristina Russo | American Express Credit Intel Freelance Contributor
6 Min Read | December 30, 2022 in Money
Buying that first home or long-awaited dream car is exciting. But as you sit pen in hand, ready to sign paperwork, you might start to wonder if you’re getting the best financing deal possible. To help avoid such a scenario – and be sure you can confidently sign the dotted line – you’ll want to get to know the concept of Annual Percentage Rate, better known as APR, and how it affects the borrowing costs of loans and credit cards.
APR is a way of measuring the all-in costs a lender charges a borrower per year. More specifically, a loan’s APR is its stated interest charges plus any fees or other costs.
APR considers all those “fine print” fees, including:
Adding these fees to the stated interest rate (sometimes called the nominal rate) helps a borrower determine the full borrowing cost of a loan. If there are no fees, the APR equals the stated interest rate. But since most personal financing products have some financing charges, APR is almost always higher than the stated interest rate.
APR is shown as a percentage of the loan amount that you pay each year. The higher the APR, the more money you will pay back over the life of the loan.
Credit card APR is a notable exception. A credit card’s APR is the same as its stated interest rate for standard purchases, not the “all-in” cost to borrow. In other words, a credit card’s APR does not include any fees that a customer might incur, such as penalty APRs and late fees, separate cash advance APRs or cash advance fees, foreign exchange fees, or balance transfer fees. These potential costs are not included in the APR because card issuers cannot reasonably forecast what fees any given customer could incur. What’s more, credit card APRs are typically variable, meaning they’re subject to change – more on that below.
There are two main types of APR, fixed and variable. If you prefer predictability, a fixed APR may be attractive because the underlying stated interest rate is set at the beginning of the loan and does not change.
In the case of a variable APR, the underlying interest rate is benchmarked to an index rate, such as the prime rate, which can change over time. As the interest rate changes, whether up or down, the APR fluctuates. Most credit cards have a variable APR that floats above the prime rate and is based on the cardholder’s personal credit history. Generally, the higher a cardholder’s credit score, the lower the interest rate they’ll receive. Further, there may be separate APRs for purchases, transfers, and cash advances.
Broadly, APR is calculated by adding up all the loan costs, dividing those by the number of years in the loan, and then adding the result to the annual interest charges to get the total cost of borrowing for one year. Finally, that total annual borrowing cost is divided by the principal amount to determine the percentage of the principal that you will repay each year – the quoted APR.
For example: Suppose you lend me $20 for a year at 10% interest, but you are also charging me a $3 fee. At the end of the year I will owe you the principal ($20), plus 10% ($2), plus the fee ($3), or 20 + 2 + 3 = $25. My total borrowing cost is $5, and 5/20 = 0.25, so the APR is 25%. This is a one-year loan at an interest rate of 10% and an APR of 25%.
Because effective APR varies with frequency of interest compounding and repayment schedules, a typical APR calculation is seldom as simple as this example. As a rule, the less frequently interest is compounded the lower the APR will be. Conversely, as payment frequency increases so does the effective APR. That may sound confusing, at first, because – if all else is equal – increasing payment frequency can reduce your total borrowing cost, help pay off your debt early, or both. But APR is only an annual rate, and cannot account for those factors. In these more complicated cases, there are several online APR calculators that can help you manage the extra layers of variables if you want to do your own calculations.
In the case of credit cards, interest charges are usually calculated using a daily periodic rate (DPR) applied to the average daily balance (ADB) and weighted for the number of days the DPR was in effect. DPR is the APR divided by 360 or 365 days. Of course, the formula is not necessary during the introductory period of a 0% APR credit card, when no interest is charged.
The wide array of financing options can seem overwhelming, especially given the recent rise in alternative online lenders. And when lenders compete for your business, they may quote their terms in the most favorable light, making direct comparisons difficult. Using APR is a way to help you cut through any marketing spin and see the full picture more clearly.
The Truth in Lending Act (TILA), enacted in 1968 and amended countless times since, requires lenders to lay out certain costs and terms in a uniform way, facilitating apples-to-apples comparisons. TILA requires disclosure of APR in consumer lending to help borrowers compare the cost of financing among various lending institutions.1
APR helps you decide which loans make the most sense for you by creating a level playing field for total borrowing costs. It helps you figure out whether to choose a financing plan with a higher stated interest rate and lower upfront fees, or one with some extra fees upfront (like points on a mortgage) that get you a lower interest rate.
A few shortcomings of APR that most borrowers should be aware of are:
While many factors go into making the best financing decisions for your household budget, APR is a useful tool to help you make an informed choice. Understanding what it means and how it is calculated can help you make sure those big-ticket purchases don’t end up costing more than you expected.