You are not alone if you have ever wondered how APR works. The APR or APR on a loan can be much more complex than a simple interest rate.
In this article, I will answer some common questions about the APR, including how it works and what it does/does not include.
What does APR mean?
The APR, or APR, is the interest rate you pay on a loan, such as a credit card or car loan, on an annual basis. Simply put, it is the cost of borrowing money.
Generally speaking, the lower the APR, the better.
How does APR work?
Your APR is shown as a percentage and includes fees and charges associated with the loan. These fees and costs will vary depending on the type of product you are applying for (e.g. mortgage loan, car loan, etc.), but here are a few examples of fees that are typically included in an APR:
- Processing fee. Banks will combine all sorts of things into a “handling fee”. For a mortgage, this may be referred to as the “initial fee”.
- Underwriting fee. The underwriter reviews your loan application and makes the final decision.
- Document fee. They usually refer to the drafting of the loan documents that you will eventually sign.
- Evaluation fee (mortgage loans). It’s the price to pay for someone to come out and rate the house.
The advantage of APR is that it gives you a very easy way to compare loan rates.
Annual Interest Rate vs Interest Rate
APR includes costs and fees associated with a loan. There is no interest rate. The interest rate is simply the rate you pay on a loan, excluding any other costs.
Considering only the interest rate is not an efficient way to evaluate a loan. APR is much more efficient because it uses the interest rate and takes into account any other costs to fund the loan, providing a much more holistic view.
When you apply for a loan, you should always be able to see both the interest rate and the APR. If you don’t, ask your lender to provide both.
Variable annual interest rate versus fixed annual interest rate
Variable annual interest rate
A variable annual interest rate is determined by using a base (or reference) rate and adding a certain percentage, known as margin, to that base. A great example of a benchmark bet would be the main bet.
If the prime rate is 3.5%, your variable annual interest rate could be 8.00% + prime rate or 11.5%. The bet is considered variable because it can change – in this case, depending on what the main bet is doing.
Fixed annual interest rate
Fixed APR is just the opposite. While there is no full guarantee that it will never change, it is certainly more stable than a variable APR.
A fixed interest rate does not use a base rate at all, instead it is a rate determined by your lender. The rate is usually determined by your credit score, but some loans and credit cards will not go below the minimum rate that the bank has set for this product.
Keep in mind that the flat rate is still subject to change if certain events occur, such as you being late on your payment or you stop paying altogether. Be sure to check the terms of the loan to know if and when the flat rate can change.
Is a lower APR always better?
In most cases, the lower the APR, the better, but not always. A great example of when a lower annual interest rate might not be the best choice is a home loan.
If you remember, APR is basically: [interest rate + the cost of financing the loan]. With some mortgages, you will receive a lower total annual interest rate, but you may have to pay higher scores, closing costs, or other fees associated with closing your mortgage.
When you apply for a mortgage or any loan for that matter, be sure to read everything in the fine print and ask the lender for as many details as possible. Sometimes what looks best on paper doesn’t fit in your pocket.
What is a good APR?
The best annual interest rate you get depends on several factors:
- The type of loan you are using (such as a credit card, car loan, or personal loan)
- Your credit score. If you have good credit, you will qualify for lower APRs.
- Basic rate
What is a good APR for a credit card?
Average interest rates on credit cards vary depending on the main interest rate. According to the Federal Reserve, the average annual interest rate across all credit cards as of August 2022 was 16.27%.
In general, any APR on a teen credit card—say, 15% or less—is pretty good. Some cards may offer APR in the 10% range, but this is rare.
What is a good APR for a car?
The annual interest on a car loan also differs depending on the loan. A good annual car interest rate for borrowers with a good and fair credit history is less than 5%. The average 60-month annual interest rate for August 2022 was 5.50% according to the Federal Reserve.
Borrowers with excellent credit history can receive interest rates ranging from 2.47% for new car loans and 3.61% for used car loans. For more average but good credit ranges, the average rate is 3.51% for new cars and 5.38% for used cars.
Read more: Best car loan rates in 2022
What is a good APR for a loan?
Typical annual interest rates for personal loans are in a wide range. In August 2022, the average APR on a 24-month personal loan was 10.16%.
Borrowers with excellent credit history can potentially receive an interest rate below 8%. But in general, any annual interest rate in the 10% range is not bad. At its highest level, the APR on a personal loan can be as high as 36% for subprime borrowers.
Read more: Best consumer loans 2022
APR Credit Card: What are the three different rates?
A credit card is a bit different from most loans in that it categorizes your purchases, each with a corresponding annual interest rate. There are usually three categories: purchases, balance transfers, and cash advances.
These three rates are usually different and you will see this on your credit card statement.
Buy per annum
The Annual Purchase Interest Rate is the interest rate charged to you on credit card purchases when there is a balance on your credit card. This is the most common type of APR credit card that is charged.
Read more: Best Low Interest Credit Cards
Annual balance transfer
An annual balance transfer percentage applies to any debt transferred from one credit card account to another. It may be higher or lower than the annual purchase price.
Many cards offer balance transfer promotions for new customers when they open credit cards. These introductory offers give you 0% or low APR on balance transfers for a limited time (usually six to 18 months). If you do not pay off the entire transferred balance by this time, the regular balance transfer rate will apply.
Read more: The Best Balance Transfer Credit Cards of 2022
Cash advance per annum
The annual cash advance rate is the interest rate charged to you for any cash you withdraw from your credit card account (for example, you use your credit card to withdraw cash from an ATM).
These APRs typically range from 25% to 30%, which is much higher than typical buy and balance transfer APRs.
Interest on cash advances starts accruing as soon as you withdraw cash. In other words, there is no grace period – unlike a purchase APR, where interest does not start accruing until the end of the billing cycle.
An example of how credit card APRs work
Let’s say you open a credit card and immediately make a $5,000 balance transfer at 0% (just remember it’s not really 0% because you’re paying a transaction fee).
After that, you shop $1,000 that month at 16.99%.
Finally, let’s say that one day you get stranded and have to use a credit card to withdraw $500 in cash from an ATM (which we strongly discourage). This is usually the highest annual interest rate, so we will say it is 25.99%.
When the first credit card bill arrives (interest has not yet been charged), you will have a new balance of $6,500 (excluding fees). However, it will be split into three different APRs:
- Balance transfers (0%): $5,000
- Purchases (16.99%): $1,000.
- Cash advances (25.99%): $500.
So, if you’re making a payment with a credit card, what is the APR that payment applies to in the first place?
Until 2009, when you made a credit card payment, it went to lowest APR first. Doesn’t make any sense, right?
This is how banks killed their customers. In effect, they could trap their customers into paying higher rates, and consumers could not pay a higher annual interest rate until they paid off all other balances first.
Using our example above, this means that $500 at 25.99% will stay there and collect interest while you make aggressive payments against the 0% balance and then the 16.99% balance (after the 0 balance % will be fully repaid).
Sound crazy? It was. At the time, I experienced this firsthand while working for a Fortune 500 bank.
Thankfully, the Credit Card Act of 2009 came along and put an end to this nonsense. Now, when you make a payment to your credit card, it is allocated to greatest APR first. So you can pay this 22.99% cash advance right away.
How to calculate the annual interest rate
Here’s how to calculate the daily APR you pay with your credit card.
Find your daily allowance
Divide the APR you get on your card by 365, the number of days in a year. This will give you your daily rate, also known as the daily periodic rate. Use decimals when you do this calculation. For example, for 17% per annum, use 0.17/365 = about 0.00046.
Your Balance Factor
Multiply the daily rate by the current balance. Let’s say you have a $500 balance on this card at 17% APR. Take your daily rate of 0.00046 and then multiply that number by 500. You get an average daily fee of $0.23 per year.
Look at the annual for the whole month
Multiply your daily payment per year by the average number of days in a month (30.44). Using the example above: $0.23 * 30.44 = about $7 you pay monthly in interest.
Summary
While APR is a quick and dirty way to evaluate and compare loan products, it should not be Only the thing you are looking at. Use it as a starting point and do as much research as you can before agreeing to any loan product.
In addition to the annual interest rate, there are many other factors to consider, such as the monthly payment, the reliability of the institution lending you funds, and whether they offer online banking or an app that you can use on the go. In other words, knowing the annual interest rate is only the first step in making a smart decision as a borrower.