What Is APR and How Is It Calculated?

Annual percentage rate, or APR, is a term that you’ve probably seen many times—whether in a personal or business context. If you’ve ever applied for a credit card or a loan of any kind, you’ll have seen an APR, specified on the terms and conditions as related to that financial product. Although you may have some idea of what APR is and how it works, you may still have some questions about the details. For example, “How does APR differ from an interest rate?”

Moreover, if you’re thinking about applying for a loan, you’ll likely want to know how APR will impact your business finances. Therefore, you may find yourself asking:

  • How does APR impact how much I pay?
  • What does this have to do with my monthly bill?
  • Why do APRs often vary from one transaction and period to the next?
  • What about when I see an annual percentage rate for other types of credit, like a business loan?

These are all valid questions and ones that you’ll want to answer before you start any processes to apply for business financing.

Luckily, we’re here to help. We’ll answer the question: “What is APR,” explaining the different types of APR, how the annual percentage rate is calculated, and more.

Let’s get started.

What Is APR?

So, let’s begin with the basics, what is APR? APR stands for annual percentage rate, and it’s actually the most important number you’ll find when applying for a small business loan or other types of financing products. APR is expressed as a percentage and it shows the entirety of what you’ll pay back to a lender—as it not only considers the interest rate, but other fees as well, such as origination fees, documentation fees, and more. Whereas interest rates are not standardized for time, an annual percentage rate solves this problem, allowing you to compare the cost of borrowing from different lenders using standard yearly rates.

APR and the Truth in Lending Act

With this overview in mind, let’s go through a brief background of APR.

In the United States, the disclosure and calculation of APR have been governed by the Truth in Lending Act since its original effective date of May 29, 1968.

The U.S. Department of the Treasury provides the following in regards to how the act protects consumers:

“The Truth in Lending Act (TILA) protects you against inaccurate and unfair credit billing and credit card practices. It requires lenders to provide you with loan cost information so that you can comparison shop for certain types of loans.”

For many years, the Truth in Lending Act was effective in creating an atmosphere of honest reporting and clarity amongst borrowers and lenders. In the 1980s, however, this all changed when automakers, among other companies, began to exploit a loophole in which they could reduce finance charges, but make up for it by increasing the price of the car.

This being said, many changes have been made over the years to fight against deceptive practices. For example, provisions were added to the Mortgage Disclosure Improvement Act of 2008 (MDIA) to provide homebuyers with more concise information. This clause states that if the final APR is off by 0.125% or more on the Good Faith Estimate disclosure, the lender must issue another disclosure and wait for a period of three additional business days before completing the transaction.

The Federal Deposit Insurance Corporation (FDIC) is responsible for enforcing laws and regulations associated with consumer protection as it relates to annual percentage rates. There are rules that govern the following:

  • Tolerance
  • Rounding
  • Periodic rates
  • Finance charges
  • Good faith reliance on faulty calculation tools

Fortunately, as a consumer, you don’t have to concern yourself with the many rules and regulations that govern business lenders. As long as you can answer the question, “what is APR?” you can rest easy knowing that there are many governing bodies that exist to keep a close eye on lenders and lending practices.

what is apr

Types of Annual Percentage Rates

Now that we know a little bit about how APR is regulated and the purpose behind this percentage, let’s dive into the details about the different types of APR.

One of the reasons that the annual percentage rate can be so confusing for many business owners is because of these multiple types of APR—in fact, a single credit card account can have multiple APRs. This being said, most people pay close attention to the annual percentage rate for purchases because they know if they carry a balance from one month to the next, this is the rate that will be used to calculate how their balance is impacted.

However, in addition to this well-known type of APR, there may be other types of annual percentage rates involved in your financing products, especially with credit cards, such as those associated with balance transfers. In the case of a balance transfer APR, if you transfer money from one credit card to another, this is the rate that comes into play.

Let’s explore the different types of annual percentage rates:

Promotional APR

Some lenders offer a promotional APR, also called an introductory or intro APR. This type of annual percentage rate gives you a lower rate on certain transactions for a predetermined period of time. For instance, you may find 0% intro APR business credit cards that allow you to carry a balance interest-free for a predetermined amount of time. Once the promotional period ends, however, your APR will adjust to a rate that will vary based on the market Prime Rate and your creditworthiness, and this will apply to any balance you have now or in the future.

This being said, a promotional APR may apply to just purchases, just balance transfers, or both—it all depends on the promotion from the credit card issuer.

Variable and Non-Variable APR

Although the naming conventions for these two APR types are somewhat self-explanatory, let’s explain a little further.

A non-variable APR is often preferred, as this means the rate stays the same indefinitely. A non-variable APR does not vary—so you know what you’re getting, which lessens the chance of a surprise down the road. This being said, however, when it comes to a non-variable annual percentage rate with credit cards, you’ll want to be sure to read the terms and conditions carefully. Many credit card offers with a non-variable annual percentage rate are not guaranteed. The issuing company may have the right to change the APR based on a variety of factors, such as market conditions and how often you use your credit card—they are required to notify you of any change though.

A variable APR, on the other hand, is an annual percentage rate that can vary over time. This APR is calculated by adding the margin, set by the credit card company, to the index (or reference rate), such as the Prime Rate. The Board of Governors of the Federal Reserve System defines the Prime Rate as:

“The prime rate is an interest rate determined by individual banks. It is often used as a reference rate (also called the base rate) for many types of loans, including loans to small businesses and credit card loans.”

If the Prime Rate increases, so will your APR. Conversely, if the Prime Rate decreases, your annual percentage rate will follow, thus making it cheaper for you to borrow money.

Moreover, when it comes to credit cards specifically, you may also see other types of APR, such as cash advance APR, or the cost of borrowing cash from your credit card—as well as penalty APR, or the rate that can be applied to certain balance when you fail to make payments on time.

How Do APR and Interest Rate Differ?

With these different types of APR in mind, let’s break down another point of confusion with regard to annual percentage rates. Although we mentioned this briefly above, it’s important to reiterate: it’s a common myth that APR and interest rate are one and the same. Although these numbers could be close, you shouldn’t expect them to be exactly the same. Often, an annual percentage rate will be higher than an interest rate.

For example, imagine you’re a business owner interested in buying an office building and have been offered a $200,000 loan at an interest rate of 6%.

As focused as you may be on the 6% interest rate, you don’t want to overlook the fact that this isn’t the APR. The reason is simple — the APR includes the interest expense, as well as other costs and fees associated with the loan. These costs and fees are not the same from lender to lender. Therefore, it’s very likely that the APR on this loan will be higher than the 6% interest rate.

This being said, as you compare multiple lenders and loan products, you don’t forget to focus on both numbers. You may find a situation in which two lenders are offering the same interest rate, but a different APR. The lender offering the lower APR is charging fewer fees, and is offering a better overall deal.

Is APR the Same as AER and EAR?

So, an annual percentage rate is not the same as an interest rate—but what about AER, or annual equivalent rate, or EAR, effective annual rate. Despite the similar-sounding names and acronyms, both AER and EAR are also different from APR.

In fact, the annual equivalent rate and effective annual rate are used to refer to the same interest rate calculation, one often associated with personal or business savings accounts. These rates are also often referred to as APY or annual percentage yield. Essentially, an AER or EAR is the rate you can expect to earn from an investment after you take compounding interest into consideration. This means the rate factors in that interest can be compounded multiple times per year depending on the number of times interest payments are made.

what is apr

What Fees Does an Annual Percentage Rate Include?

Now that we know that a differentiating factor between an annual percentage rate and interest rate is that APR includes additional fees, let’s discuss in more detail what kind of fees this percentage includes. On the whole, fees included in APR will vary from one lender to the next. However, these fees are almost always included:

  • Underwriting fee
  • Loan processing fee
  • Private mortgage insurance fee (if applicable)
  • Document preparation fee

Along with the above, this fee is sometimes added:

  • Loan application fee

Although not always true, these are the fees that are not typically included:

  • Attorney fee
  • Abstract fee
  • Title fee
  • Credit report
  • Transfer taxes
  • Appraisal fee
  • Home inspection fee

With this in mind, it’s important that you ask any lender for more information on what is included in the annual percentage rate. This ensures that you are comparing apples to apples, allowing you to make an informed and confident decision as to which loan or financing product is the cheapest.

How Is APR Calculated?

As we mentioned briefly above, annual percentage rates for business credit cards are typically based on the market Prime Rate, and are therefore a combination of this rate with the bank’s margin. When it comes to calculating the APR for a loan, on the other hand, things are a little different.

To calculate APR on a loan, then, you first need to know the interest, the total loan amount, the terms, and the fees.

What’s the APR formula?

Let’s assume, for example, that you’re going to borrow $10,000 and have been quoted an interest rate of 12%.  You also have to pay a $500 closing fee. So, based on this information, the APR on your two-year loan would be roughly 16.92%. How did we get this number?

The simplest way to calculate APR is to use an APR calculator or a spreadsheet. For instance, in Google Spreadsheets, you can calculate the monthly payment and closing costs for the scenario described above with built-in formulas.

Let’s break it down.

Step 1. Type the following formula into any cell to calculate the monthly payment for your loan:

=PMT (interest rate/months, the total number of months you pay on the loan, loan value plus fees)

=PMT (.12/12, 24, 10500)

With this calculation, your monthly payment would be $494.27.

Step 2. Once you have determined the monthly payment, you can use a second formula to determine your APR:

=RATE (total number of months you pay on the loan, your monthly payment expressed as a negative, the current value of your loan)

=RATE (24, -494.27, 10000)

With this calculation, you’ll see that your monthly rate is .0141.

Step 3. Using your monthly rate of .0141, multiply by 12 to get an annual rate:

.0141 * 12 = .1692

This calculation yields an annual rate of .1692.

Step 4. Finally, multiply by 100 to convert from a decimal back to a percentage:

.1692 * 100 = 16.92%

With this final calculation, you’ll see that your annual percentage rate is 16.92%. Once again, although you can follow these steps in Google Spreadsheets to calculate your own APR, you can also use a number of online calculators—where you’ll simply fill in the required information—and you’ll receive your annual percentage rate.

How Annual Percentage Rate Affects Your Financing

Now that we’ve answered the question, “What is APR,” and discussed the different types and how this rate is calculated, let’s continue this guide by explaining the ways in which APR affects your business financing.

First, it’s important to note that a higher credit score will qualify you for a lower APR. It doesn’t matter if you are applying for a business credit card, seeking a home mortgage, or in need of a business loan, a high credit score will work in your favor. There are many benefits of a high credit score, with this being at the top of the list. A lower annual percentage rate, of course, means you’ll be paying less for the cost of borrowing money.

Along these lines, if you’re quoted at a certain APR, there are ways to try and get a lower rate, but they’re not always successful. Nevertheless, if you do decide you want to try and secure a lower rate, there are a few things you can do:

  • Contact the lender and request a lower APR. You should make sure you have a leg to stand on, such as details of a better offer from another lender.
  • Enroll in a debt management program. Typically, this option is only for those who are having a difficult time meeting their monthly obligation. In this case, the lender may temporarily lower the annual percentage to help the person or business get back on track.
  • Apply for a hardship plan. This is similar to a debt management program. The primary difference is that this typically keeps the lower APR in place until the balance is paid off.

Ultimately, a lower annual percentage rate is always better for your business, but you should not expect to be in a position to negotiate this on a regular basis (if at all). This is why, as you may imagine, it’s so important to seek the best offer upfront. It may not sound like a big deal when applying for a loan or credit card offer, but one APR point can make a huge difference. Over the course of 10+ years, a reduction of one percentage point will save you thousands of dollars.

Finally, although this may not be an option with a loan, you’ll always want to try and pay your balance in full, if you can. With a credit card, for example, if you never carry a credit card balance from one month to the next, you will not have to concern yourself with paying interest and therefore, your APR will not have an effect on your finances.

what is apr

Is APR the Only Factor That Matters When Applying for Financing?

As we mentioned, the annual percentage rate may very well be the most important number that you see when you apply for financing—whether for a credit card or a loan. This being said, in the case of loans specifically, it’s possible that if all other features are the same, choosing the best loan for you might come down to the APR. After all, the lower your annual percentage rate, the less you will pay in interest and fees.

However, despite the importance of APR, this is not the only thing that you should be looking at when applying for or comparing different financing products. You should also consider other details, such as:

  • The reputation of the lender
  • The lender’s customer service
  • Collateral or guarantee
  • Term
  • Payment options
  • Penalties (such as prepayment penalties)

Moreover, it’s also worth considering that because APR relies so heavily on time periods, that comparing different APRs for loans of different lengths may not be as reliable to determine which loan is the better deal.

Plus, the way you compare APR numbers for a loan, as well as other details, will not be the same as the way you compare the features of a credit card. With a loan, you know you will absolutely be paying fees to receive the capital—meaning the annual percentage rate will always come into play. With a credit card, on the other hand, as we mentioned above, if you pay your balance in full, the APR will not make as much of a difference. Therefore, you might instead consider factors like annual fees, rewards programs, and other perks above the annual percentage rate.

Annual Percentage Rate (APR): The Bottom Line

Considering everything we’ve discussed, you should have an answer to the question “What is annual percentage rate?”

However, like many parts of business financing, APR can be complicated, so you should never hesitate to consult with the credit company or financing company you’re interested in doing business with for more information regarding your rates and how interest and fees work.

Nevertheless, now that you have a better sense of how an annual percentage rate works and how it factors into business financing products like credit cards or loans, you’re in the best place possible to make decisions for your business finances, as well as for your personal finances. Just remember, although APR is important, it’s not the only factor involved with these types of financial decisions, and therefore, you’ll want to make sure you look at and understand all the details before deciding what product or offer is best for you.

Founding Editor and VP at Fundera at Fundera

Meredith Wood

Meredith Wood is the founding editor of the Fundera Ledger and a vice president at Fundera. 

Meredith launched the Fundera Ledger in 2014. She has specialized in financial advice for small business owners for almost a decade. Meredith is frequently sought out for her expertise in small business lending and financial management.

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