Meet Alberto. Alberto has multiple credit cards with high balances. But despite making regular payments, his debt seems to be increasing. How is that possible?
If you’ve ever used a credit card or borrowed money, you may have come across the term APR, which stands for annual percentage rate. But what is APR, and why is it preventing Alberto from paying off his debt?
What Is APR (Annual Percentage Rate)?
APR is the cost of borrowing money expressed as a percentage. It’s an annual rate that includes both the interest the lender charges on the amount you borrow and any other fees associated with the loan, such as origination fees and closing costs.
In the case of mortgages, APR also subtracts any points you purchase from the interest rate. Points are percentage points a borrower can buy upfront to reduce the interest rate over time.
By law, lenders must disclose the APR to borrowers so they can compare the cost of different loans or credit cards. The APR allows borrowers to see the cost of borrowing over the life of the loan or credit card and can help them make more informed decisions about which lender or credit card to choose.
You pay APR on all types of credit, such as credit cards, loans, and mortgages. Even unusual forms of credit like payday loans and casino chips can have an APR.
Why Is APR Important?
APR is important because it affects what you do during every step of the borrowing process.
- Finding the best deal. When shopping for a loan, compare APRs from different lenders to find the best deal. A loan with a lower APR costs less money over time, though APR isn’t the only important factor to consider.
- The cost of borrowing money. A higher APR means you’re paying more in interest and fees over time, so lower APRs save you money.
- Your credit score (indirectly). If you consistently make payments on time and keep your credit card balances low, your credit score may improve, which could lead to lower APRs on future loans. However, if your APR makes your payments too high or you max out high-APR credit cards and have difficulty paying them off, your credit score could suffer, and you may end up with even higher APRs.
Variable vs. Fixed APR
When shopping for a loan, you may come across two different types of APRs: variable and fixed. Understanding the difference can help you make an informed decision.
A variable APR can change over time based on market conditions. Interest rates (and therefore APRs) go up or down based on benchmark rates like the prime rate, which in turn goes up or down based on the federal funds rate, aka that federal interest rate you keep hearing so much about.
Variable APR can be lower than a fixed APR when you first take out a loan. That makes it an appealing option for borrowers who want to save money in the short term. However, variable APRs can also be unpredictable and may increase over time, making it difficult to budget for monthly payments.
A fixed APR remains the same for the life of the loan, which means your monthly payments stay consistent. A fixed APR may start out higher, but it won’t increase unexpectedly, giving you more stability and predictability in your payments.
However, fixed APRs are often higher than variable APRs, which means you may end up paying more in interest over time if benchmark rates remain low.
When deciding between a fixed and variable APR, consider your personal financial situation and long-term goals. If you prefer predictability and want to avoid the risk of rising interest rates, a fixed APR may be the best option. However, if you’re comfortable with some uncertainty and risk and want to save money in the short term, a variable APR may be a better choice. You may be able to refinance to a fixed rate later.
Types of APR
Calculating APR works the same way no matter what it’s called. However, you may run across APR types that work differently based on when and how you encounter them. It’s crucial you understand how each one works since it impacts when you owe money and how much.
If you pay your credit card balance in full each month by the due date, you never incur a penny of interest. But most of us don’t do that.
And the amount you pay on everyday items like groceries, gas, and clothes if you carry a balance into the next month is called your purchase APR.
Balance Transfer APR
Many credit card companies offer promotional balance transfer APRs, which can be much lower than their regular purchase APRs. A balance transfer APR is the interest rate you pay when you transfer a balance from one credit card to another.
Balance transfer APRs can help you consolidate debt and save money on interest, but read the fine print. Promotional rates usually expire after a certain period, and if you don’t pay off your balance in full by then, you may end up owing back interest at a much higher rate.
Cash Advance APR
A cash advance APR is the interest rate you pay when you withdraw cash from your credit card.
Cash advances usually come with much higher APRs than purchases and balance transfers. They also often come with additional fees, such as cash advance fees and ATM fees. They’re expensive, so only use cash advances in emergencies.
A penalty APR is a higher interest rate credit card companies may apply if you miss a payment or violate other terms of your agreement.
Penalty APRs can be significantly higher than regular purchase or balance transfer APRs, and they can make it even more difficult to pay off your debt. To avoid penalty APRs, always pay your bills on time and read your credit card agreement carefully.
An introductory APR is a promotional interest rate credit card companies offer for a limited time, usually six to 12 months. Introductory APRs can be much lower than regular purchase or balance transfer APRs, making them a good option for big purchases or consolidating debt.
But read the fine print. Once the introductory period is over, the APR will go up, sometimes dramatically. Be prepared to pay off your balance or transfer it to another card before the promotional period ends.
How to Calculate APR
The easiest way to calculate APR is to use a reputable online APR calculator. In fact, that’s recommended.
But if you want to do it manually, it’s not so difficult you need to be a math nerd to do it. And frankly, it helps to understand the concept. For example, you quickly understand why it’s called an “annual” percentage rate even though you pay it monthly and how it really differs from straight interest.
The formula looks like this:
That looks more complicated than it is. Note that interest means the total interest you’d pay over the life of the loan (not monthly) minus any points, and the fees are any fees added to the loan itself (not things you pay upfront).
Let’s say you borrow $10,000 for a period of 3 years (1,095 days), with an interest rate of 6% and fees of 3% of the principal.
First, we need to calculate the total cost of borrowing, which includes both the interest and fees:
Interest = Principal x Rate x Time – Points
Interest = $10,000 x 6% x 3 – 0
Interest = $1,800
Fees = Principal x Fee Rate
Fees = $10,000 x 3%
Fees = $300
Total Cost of Borrowing = Interest + Fees
Total Cost of Borrowing = $1,800 + $300
Total Cost of Borrowing = $2,100
Next, we can use the formula to calculate the APR:
APR = [((Interest + Fees) ÷ Principal) ÷ Days in the Loan Term] x 365 x 100
APR = [($2,100 ÷ $10,000) ÷ 1,095] x 365 x 100
APR = (0.00021) x 365 x 100
APR = 7.665
Therefore, the APR for this loan is approximately 7.665%.
Nominal APR vs. Effective APR
Nominal APR is the APR as stated by the lender or credit card issuer. It doesn’t take compounding interest into account.
Effective APR does consider compounding interest and therefore reflects the true cost of borrowing.
Lending institutions don’t use the effective APR when quoting rates for two reasons: It’s usually a higher number and it’s not legally required. Also, the math is pretty complicated.
When comparing loans and especially credit cards, you may not care much because they’re off by the same general amount if they’re close anyway. But you’ll definitely care once you start paying it back, especially if it’s a credit card compounded daily, which most are.
So if you’d like to know the effective APR, you can calculate it, assuming you have a calculator that can handle exponents.
You’ll just need the daily periodic rate, which credit cards provide, either outright or in the fine print.
Let’s say you find a card with a nominal APR of 18.25%. In the fine print, it says the daily periodic rate is 0.05. First, congrats on that stellar credit score. Second, the daily periodic rate is usually some crazy number like 0.05987. I’m just trying to make the math easy.
The daily rate makes sense since if you multiply 0.05 x 365, you get 18.25. Easy-peasy. But if you want the effective APR, you have to take into account that the interest rate is compounded daily.
First, convert 0.05% into a standard number by moving the decimal to the right twice to get 0.0005. Then add 1 since numbers less than 1 often yield weird results if the calculator rounds (it will round to 0!). So we have 1.0005.
Now, we do 1.0005 to the 365th power (1.0005365). That’s 1.20016. Now, subtract that 1 to get 0.20016. Move the decimal back over to the left, and we’ve got an effective APR of 20% (20.016).
You’re probably better off using an online effective APR calculator.
How to Find Out the APR
The easiest way to find out the APR is to look for it in the loan or credit card agreement. The law requires all lenders to disclose the APR, so it should be easy to find. You can also find the APR on the lender’s website, in promotional materials, or by calling the lender directly.
You can also use online resources to compare APRs from multiple sources at once. For example, click the Credit Cards link in the navigation of our website to see our comparisons and reviews.
You’ll get a more accurate estimate if you apply since they can base it on your details. To prevent that from impacting your credit score, stick with a comparison site like Credible, which doesn’t do a hard credit check to present you with multiple offers.
Factors to Consider When Comparing APRs
When comparing APRs, it’s important to consider other factors that can affect the cost of borrowing. Consider the total cost of borrowing, including fees, interest, and any other charges associated with the loan. Also, think about your personal financial situation and whether the loan fits your budget and long-term goals.
Things to think about before you start shopping include:
- Your credit score: Borrowers with higher credit scores may qualify for lower APRs. If yours could use some work, improve your credit score before you start shopping to get the best deal.
- The loan amount: Larger loans may come with lower APRs since banks can make more money off them without the additional admin costs of several smaller loans. So if you see one institution advertising a lower APR than another, check to see if they’re the same loan amount.
- The loan term: Loans with shorter terms may come with lower APRs. But they also usually come with higher monthly payments. Saving money on interest does you no good if you can’t fit the monthly payment into your budget.
- The type of loan: Vehicle and mortgage loans usually have lower APRs than personal loans and especially credit cards because they’re secured (backed by collateral the bank can take back if you don’t pay).
- Fees: Since certain types of loan fees are included in the APR, if you can negotiate those down, you can lower your APR. For example, if you buy a house, the more of the closing costs the seller pays, the lower your APR.
Comparing APR to Similar Terms
APR is not the only term you’ll encounter when borrowing money, and unfortunately, some of them are easy to confuse with APR. But it’s important to understand the difference.
The interest rate is the amount the lender or credit card issuer charges you as the cost of lending you the money. It’s a percentage of the loan amount that you must pay monthly along with paying off a portion of the principal.
While APR includes interest rates, it also includes other fees, so it provides a more accurate picture of the total cost of borrowing.
APY, or annual percentage yield, is similar to APR, but it’s used to calculate the interest earned on savings accounts or other interest-bearing accounts. APY takes into account the compounding interest you earn over time, while APR doesn’t.
Simple interest includes only the interest of a loan or investment — no fees and no compounding. It’s not really different from the interest rate mathematically, but when you call it “simple interest” you’re typically referring to a method of calculating the lender’s charge for the loan.You typically hear it in relation to short-term loans, such as payday loans.
If a loan has simple interest calculated at a specific time, such as daily or monthly, you calculate the interest on the principal amount only and add that to the total.
Compound interest is calculated on both the principal amount and any interest earned over time. It can add up fast. Compound interest is why some people say that letting interest accrue is paying interest on interest. It’s used for longer-term loans, such as mortgages and car loans.
If a loan has compound interest calculated at a specific time, such as daily or monthly, you calculate the interest on the total amount due (both principal and interest) and add it to the total.
APR and finance charge tend to be thrown around interchangeably, but they’re not the exact same thing. The APR is the total cost of the loan over one year only, including interest and fees (minus points), expressed as a percentage. The finance charge is the total cost of the loan overall, including interest and fees (minus points), expressed as a dollar amount.
Frequently Asked Questions about APR
Understanding these common details about APR can help you make informed financial decisions and avoid costly mistakes.
What Is a Good APR?
That’s a loaded question.
A good APR is lower than the national average for that particular type of credit. But what’s average changes based on the current interest rates, and credit types have such wildly different prevailing rates
For example, credit cards tend to be in the double digits no matter what, though people with good credit may land in the teens while those with average or bad credit stay in the 20s. Vehicle and home loans, on the other hand, tend to have rates in the low to medium single digits for well-qualified buyers.
And APRs can vary widely based on factors like your credit score, the type of card, and the issuer. What’s good for someone with a score of 690 might be suboptimal for someone who’s score is almost 800.
Is APR the Same as the Interest Rate?
No, APR includes both the interest rate and other fees associated with the loan, while the interest rate is just the cost of borrowing the principal amount. The APR gives a more complete picture of the total cost of borrowing.
Why Is the APR on a Credit Card So High?
Credit cards are unsecured loans, meaning there’s no collateral for the lender to seize if the borrower defaults. Additionally, many credit card companies offer rewards programs and other perks to entice customers, which they fund in part by charging higher interest rates.
Furthermore, factors such as the borrower’s credit history and the overall state of the economy can influence APR.
How Do I Calculate APR?
By taking the total amount of interest and fees you pay over the course of a year and dividing it by the amount you borrowed. You can also use an online calculator.
Can I Negotiate APR?
Maybe, but it depends on the lender and your creditworthiness. If you have good credit and a good relationship with the lender, you may be able to negotiate a lower rate. It’s worth trying, but there’s no guarantee you’ll be successful.
Start by researching the market rate for similar loans or credit cards, then use that information to negotiate a lower rate with the lenders or credit card issuers you ultimately choose. It may be easier to negotiate lower financing fees than to lower the interest rate itself, but both will lower your APR.
You can also use your credit score as a bargaining chip. For example, if your credit score has increased since you took out the credit card, they may be willing to update your contract. To lower the APR on a loan because of an improved credit score, you must usually refinance into a new loan.
Borrowers with dinged credit or a limited income may also be able to qualify for a lower APR by adding a co-signer with a higher credit score or income. Just note that if you don’t pay, the lender will go after them for the money.
How Can I Lower My APR?
You can lower the APR lenders or issuers might offer yoyu by improving your credit score or paying down debt before you apply.
If you already have a loan but you’ve improved your financial situation in some way, try refinancing. If it’s an existing credit card with a high APR, you can transfer the balance to a card with a lower APR or introductory balance transfer rate, but be aware of any fees associated with balance transfers.
Does a Lower APR Always Mean a Better Deal?
Not necessarily. While a lower APR can mean paying less in interest over time, it’s not the only factor to consider when choosing a loan or credit card. Other factors like fees, repayment terms, and credit limits can also impact the overall cost and value of the credit. It’s important to consider all aspects of the credit agreement when making a decision.
APR is an important factor to consider when choosing a credit card, but it’s not the only one.
A low APR can help you save money on interest charges. But you also need to consider other factors like annual fees, rewards programs, and credit limits. APR isn’t even the only way credit card companies can make money off you, so read the fine print and understand all of the terms and conditions before applying for a card.
Ultimately, the best credit card for you depends on your individual needs and financial situation, so do your research and compare all your options before making a decision.