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What is APR? You may find yourself asking this question for a variety of reasons, such as when applying for a credit card or comparing business loan offers.
APR, also known as annual percentage rate, is defined by Investopedia as:
“…the cost per year of borrowing. APR is not the same as the interest rate on a loan. Loans charge an interest rate, but usually also charge other fees, such as closing costs, origination fees or insurance costs, which are typically wrapped into the loan. If two loans have the same interest rate, but one has much higher fees than the other, simply shopping by interest rates won’t give an accurate comparison of the loans’ true costs. That’s why there is the APR. By factoring in other fees, APR gives a more accurate estimate of the cost per year of a loan. For this reason, the APR is generally higher than the interest rate.”
As simple as that sounds, you are still likely to have some questions. These may include:
These are all valid questions. They are also questions you need to answer sooner rather than later. After all, APR impacts your finances in many ways.
It doesn’t matter if you are trying to better understand your credit card statement or seeking a loan for your small business, once you understand the answer to the questions “what is APR,” including the finer details of APR you will have an easier time managing your finances and knowing when your APR is too expensive.
So, what is APR? Let’s dive in.
What is APR?
In the United States, the disclosure and calculation of APR has 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 1980’s, 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.
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 percent or more on the GFE 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 APR. There are rules that govern the following:
Fortunately, as a consumer, you don’t have to concern yourself with the many rules and regulations that govern lenders. As long as you can answer the question, “what is APR?” you can rest easy knowing that there are many governing bodies with a close eye on lenders and lending practices.
There are many reasons for the confusion surrounding APR, including the fact that a credit card account can have multiple APRs. Most people pay close attention to the APR for purchases. They know one thing to be true: if they carry a balance from one month to the next, this is the rate that will use to calculate how their balance is impacted.
However, there may be other types of APR, such as those associated with balance transfers. If you transfer money from one credit card to another, this is the rate that comes into play.
Adding to the confusion is the fact that some lenders offer a promotional APR. This gives you a lower rate on certain transactions for a predetermined period of time. For instance, you may find a credit card offer with zero percent APR for six months. When the promotional period ends, the APR will adjust to a higher amount, thus increasing the cost of carrying a balance.
The name pretty much says it all, but do you truly understand how a variable and non-variable APR differs?
A non-variable APR is often preferred, as this means the rate stays the same indefinitely. You know what you are getting, which lessens the chance of a surprise down the road.
Note: read the fine print, as many credit card offers with a non-variable 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.
A variable APR is exactly what it sounds like: with this, your APR can vary over time. This is calculated by adding the margin, set by the credit card company, to the index (or reference rate), such as the Prime Rate. If the Prime Rate increases, so will your APR. Conversely, if the Prime Rate decreases, your APR will follow, thus making it cheaper for you to borrow money.
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.”
Although we touched on this above, it is important to reiterate: it is a common myth that APR and interest rate are one and the same. While these numbers could be close, don’t expect them to be exactly the same. Oftentimes, an APR can be higher than an interest rate.
Here is an example:
You are a business owner interested in buying an office building and have been offered a $200,000 loan at an interest rate of six percent.
As focused as you may be on the six percent, don’t 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.
The APR will almost always be higher than the interest rate.
As you compare multiple lenders and loan products, 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 if offering a better overall deal.
To calculate APR, you first need to know the interest, the total loan amount, the terms, and the fees.
Let’s assume 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, the APR on your 2-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.
1. Type the following formula into any cell to calculate the monthly payment for your loan:
=PMT(interest rate/months, total number of months you pay on the loan, loan value plus fees)
=PMT(.12/12, 24, 10500)
Your monthly payment would be $494.27
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)
3. Your monthly rate should be .0141. Multiply by 12 to get an annual rate:
.0141 * 12 = .1692
4. Finally, multiply by 100 to convert from a decimal back to a percentage:
.1692 * 100 = 16.92%
The fees included in APR can and will vary from one lender to the next. These fees are almost always included:
Along with the above, this fee is sometimes added:
While not always true, these are the fees that are not typically included:
Note: ask each lender for more information on what is included in the APR. This ensures that you are comparing apples to apples, allowing you to make an informed and confident decision as to which loan is cheapest.
Any misunderstanding in regards to the question, “what is APR,” such as how it is calculated, could lead to a situation in which you are surprised at what you are being charged.
These three facts can help you better understand your situation:
1. A higher credit score will qualify you for a lower APR. It doesn’t matter if you are applying for a 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.
2. There are ways to get a lower APR, but don’t count on this happening. If you want to attempt to secure a lower rate, there are things you can do:
A lower APR is always better, but you should not expect to be in position to negotiate this on a regular basis (if at all). This is why it is 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.
3. Paying the balance in full is the best way to go. This definitely holds true with a credit card. If you never carry a balance from one month to the next, you will not have to concern yourself with paying interest.
This may be an option with a credit card, but not with others, such as a business loan.
Now that you fully understand how to answer the question, “what is APR?” including its basic definition and how it is calculated, it is time to dive into some of the more detailed questions.
It is very easy to have a one-track mind when it comes to applying for a credit card or loan. With a loan, your goal is simple: secure the funding you need to make a purchase, without paying too much to do so.
There is no denying the benefits of comparing the APR associated with multiple loans. If all else is equal, the APR could be the determining factor. The lower the number the less you will pay in interest and fees.
Despite the importance, this is not the only thing that matters. There are other details to consider, such as:
Note: the way you compare APR numbers for a loan will not be the same as a credit card. With a loan, you know you will absolutely be paying fees to receive the capital. This means the APR will definitely come into play. With a credit card, this isn’t always true, since you have the option of paying your balance in full every month.
If you’re still wondering, “What is APR?” don’t hesitate to consult with the credit card company or financing company you are interested in doing business with.
As you continue to grow your small business or improve your personal finances, you may find yourself interested in some type of loan (business loan, mortgage, etc.) or in business credit cards. With each step that you take, make sure these three letters are in the back of your mind: APR.