- The annual percentage rate factors can inform borrowers how much they will owe in interest and other charges over the course of a loan.
- APRs commonly apply to multiple types of loans including mortgages, auto loans, and credit cards.
- Knowing how APR works can put you in a better position for financial success.
When watching a commercial for a new credit card, auto loan, or mortgage loan, you’re likely to come across the term “annual percentage rate” or “APR.” Typically, the credit card company or lender will squeeze this term in somewhere at the end of the advertisement when they’re discussing the various terms and conditions.
If you’ve ever wondered what the annual percentage rate is or how to calculate APR, you’re in luck. Today, we’re here to provide a complete breakdown of different APRs and how to calculate them so you can better plan for your financial future.
Defining and Learning How to Calculate APR
According to the credit bureau Experian, the annual percentage rate (APR) “is the interest rate lenders charge when you borrow money. APR incorporates the interest the bank or finance company will charge, plus fees and other costs, into a single percentage rate that helps you determine how much the loan or credit card will actually cost you in a year.”
Therefore, APR is a far better indicator than just the annual interest rate of the total cost of a loan, mortgage, or credit card.
The formula used to calculate APR is:
APR = (((Fees + Interest)/Principal)/n) *365) x 100
Interest represents the total interest paid over the life of the loan. Fees are all the other charges associated with the loan along with any other additional costs. The principal is the total loan amount. “N” stands for the number of days in the loan term.
The steps to calculate APR are:
- Add up total interest paid over the life of the loan and all additional fees.
- Divide this answer by the number of days in the loan term. So if it is a 10-year term, the number of days is 3,650 (10 x 365). This gives you the daily cost of borrowing.
- Multiply your answer in #2 by 365, which gives you the annualized rate.
- Multiply your answer in #3 by 100 to give you a percentage rate and the APR (the “Annualized Percentage Rate”) cost of borrowing.
So, calculating APR is an excellent way to see how much you are being charged for borrowing (including interest and fees), expressed as a percentage of the principal you borrowed. This is one of the benefits of using APR.
APR is a useful tool when choosing between different lenders (mortgage, auto, credit card) because each lender has to follow the same calculation. When shopping for the best rates, you can use the APR for an “apples-to-apples” comparison of the cost of borrowing for each lender.
Knowing this “apples-to-apples” cost of borrowing with the APR, you can also compare other factors of the loans you’re considering, such as the term (for how long you’ll make payments), the trade-in value of your car, or even whether any rewards you’ll earn when opening the credit card are worthwhile.
Lenders are required to disclose the APR, the interest charges and fees included, and how it is calculated — so review the disclosures closely. Typically, consumers see APR conveyed for three different types of lending: mortgages, auto loans, and credit cards.
If you’re trying to save for and buy a house, the mortgage APR should be a primary concern. Not only does the APR account for interest charges, but can also consider items such as:
- Mortgage broker fees
- Origination fees
- Points, which are fees you can pay to the lender at closing to reduce the interest rate
- Closing costs
- Other expenses associated with the loan
When looking at mortgage APRs, you may come across adjustable-rate loans and fixed loans. An adjustable-rate mortgage is one with a fluctuating interest rate. The interest rate will vary at some point in the life of the loan, typically as a result of your credit score. The fluctuating rate can alter the total amount of interest the borrower will end up paying.
Typically, lenders will establish a fixed rate for an initial period. After this period expires, the variable rate kicks in, so the rate resets periodically. Some lenders may reset the rate annually while others may do it monthly.
Fixed-rate mortgage loans are much more straightforward. The rate remains the same throughout the term of the loan.
When comparing mortgage APRs, you want to make sure that you’re comparing the same type of loan. For instance, you should not compare a fixed-rate APR to a variable APR.
Auto Loan APR
Another scenario where the APR will come into play is with auto loans. Auto loan APRs are much like mortgage loan APRs. The interest rate reflects the percentage of interest you’ll pay on the remaining principal of your loan each due date. But the APR accounts for everything charged to you for borrowing money, including origination fees.
If you’re in the market for a new vehicle, look for those that offer low APRs, as these will end up saving you the most money over the life of the loan. You can compare rates from various lenders ?— some auto loan lenders are even available online. Lenders can help the average consumer secure competitive financing for an upcoming vehicle purchase.
Credit Card APR
Credit card APR is a bit more challenging than those for mortgages and auto loans. Mortgage and auto loan APRs account for monthly payments on a fixed loan amount. Credit card APRs are a bit different, however, because the loan amount fluctuates depending on your spending and repayment habits. That’s why credit cards are known as “revolving credit,” meaning the balance “revolves” by going up and down.
When calculating credit card interest charges, the APR is charged on your credit card balance which can also include any interest charges if you haven’t paid off your balance. In other words, the interest the company has charged you compounds on itself month after month so long as you carry a balance.
Credit card APRs do not consider compound interest, so they don’t paint as full a picture about the cost of borrowing as they do when dealing with mortgages and auto loans. Additionally, when calculating credit card APR, you’ll find that there are various other types available. We’ve listed some of them below.
Many credit card companies will offer an introductory APR, typically for six months to one year. The initial APR may be very low and sometimes even 0%. However, there are a few ways to default on this attractive introductory rate before the introductory period expires. For instance, if you miss a payment or violate the terms of the agreement, the regular APR will kick in.
This APR refers to purchases that you make with the card. If you pay the full balance off the following month, you can avoid paying interest. But if you don’t pay off the balance, the purchase APR kicks in. Due to interest being added to your loan balance (compound interest), the amount you owe can grow quickly.
Balance Transfer APR
Balance transfers can be an excellent tool to help consolidate debt and pay it off at a lower interest rate. However, there is often a fee associated with balance transfers. Credit card companies may also have a special APR specifically for balance transfers. The balance transfer APR could be different than the purchase APR.
If you fall behind on your payments by more than 60 days, there’s a strong chance that your credit card company will enact a penalty APR. The penalty APR tends to be significantly higher than the card’s standard APR, often reaching as high as 30%. Your debts could spiral quickly as a result of compounding interest, and your credit score will certainly take a hit.
Cash Advance APR
If you use your credit card to withdraw cash at a convenience store or ATM, you’ll pay an APR on the amount that you withdraw. Much like the penalty APR, the cash advance APR tends to be significantly higher than the purchase APR, and may even come with a fee.
Also, this APR kicks in as soon as you withdraw the funds. You don’t have a chance to repay the balance quickly even if you’re able to or if you change your mind. As soon as you take money out of the ATM, you’ll owe interest and perhaps even fees.
Take Control of Your Financial Future
Being sucked into such a high annual rate is a great way to quickly find yourself in debt. No matter if you’re looking for a car, house, or credit card, do your research when choosing a lender. Be sure to consider loan offers and consider the APR of each.
Lenders are required to disclose loan details thanks to the Truth in Lending Act. The information is readily available to you as a consumer — you just need to know how to take advantage of and interpret the data. A sound understanding of the annual percentage rate and how to conduct an APR calculation could help you take control of your finances.