When you borrow money, you’ll likely pay interest. APR stands for annual percentage rate and it represents the costs per year of taking out a loan.
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What is APR and how does it work?
The annual percentage rate (APR) is the yearly cost of borrowing money, expressed as a percentage. The rate can fluctuate depending on the financial institution, type of loan, and the prime rate.
Related: How to get a personal loan
When a lender determines the APR, it includes the fees that you may be charged and all of the other costs.
It’s important to understand this because you’ll have a better grasp of what the lender is charging you, which helps you determine whether or not you can afford to get the loan.
Generally, a higher APR represents a loan that’s riskier for the lender, which can be a result of your credit or the type of loan. A lower APR stands for a less risky loan, or that you have a great credit score.
For example, unsecured loans are riskier than secured loans because the lender doesn’t have collateral to take if you don’t make your payments. Therefore the rate will be higher.
The following is the formula for calculation the annual percentage rate:
How to calculate annual percentage rate:
- Add up all of the fees and total interest paid over the life of the loan.
- Divide your result by the principal loan amount.
- Divide that number by the number of days in the term of the loan.
- Multiply the result by 365, which tells you the annual rate.
- Multiply the rate by 100 to get the percentage.
APR differences with loan products
The type of loan plays a role in the rate. For example, an auto loan is secured by collateral, and you have an agreement with the lender for the length of time that you’ll pay it back.
On the other hand, a credit card’s APR is only charged if you carry a balance. If you pay your bill in full and on-time every month, you only pay for what you spent.
When you compare a credit card with an auto loan, you’ll find that auto loan rates are significantly lower. Why is that?
The reason auto loan rates are lower is that the lender uses the car as collateral. If you don’t make your payments as agreed with the lender, they’ll repossess your car and usually sell it through an auction.
With a credit card, you can easily go over the limit and not make your payments. In that case, the lender can close your credit card account and you’ll owe them the outstanding amount. This is riskier because they can’t take your card and recover the funds by selling it.
Different products will have different rates. Depending on the risk of the loan, your credit score, debt-to-income ratio, and other factors the lender considers, you’ll find different rates.
Variable vs. fixed
Another aspect of APR is whether it’s variable or fixed. A variable APR means that the rate can change, whereas fixed means that it’ll remain the same for the life of the loan.
The benefit of a fixed rate is that you’ll know the amount that you’ll pay before you get the loan.
A variable-rate can decrease or increase. When it decreases, you’ll pay less interest. When it increases, you’ll pay more, so it’s riskier.
Most loans won’t give you the option to choose between the two. If you get the choice, you’ll need to consider what your financial goals are, and the state of the economy.
For example, if the rates are currently low all-around, and you get the option to start with a variable rate then fix it in the future, it can save you more money than starting with a fixed-rate at a higher rate.
Frequently asked questions
Annual percentage rate (APR) is what you pay to borrow money, whereas annual percentage yield (APY) is what a financial institution pays you for keeping your money in your bank account.
For most loans, it does. However, credit cards are the exception because you only pay interest when you carry a balance.
Divide the APR by 365. This is known as the daily periodic rate.
Having a solid understanding of what APR is and how it’s calculated can be beneficial for you to make good decisions. It’ll also help you understand the total amount that you’ll pay to get the loan, which will help you determine whether or not you should move forward with it.
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About David Em
David Em is the founder of More Money More Choices, which he launched to help you take control of your finances and build your dream life. Before More Money More Choices, David worked in leadership positions in the finance industry.