Annual Percentage Rate (APR): The Impact on Borrowing Costs

Annual percentage rate (APR) is a term used to describe the costs banks and other lenders charge when you borrow money, either through a loan, a credit card, or another financial product. That said, APR includes more than the interest rate you'll pay since it also wraps in fees you cannot avoid.

That's why some financial products have an APR that is different from their interest rate. If you're curious about the APR definition and the different types of APRs out there today, read on to learn more.

Key Takeaways

• There are costs associated with borrowing money, whether via a credit card, a mortgage, or a personal loan. You typically have to pay back the amount you borrow, plus interest and fees. 
• The annual percentage rate (APR) for a loan or a credit card encompasses the interest charges and fees you have to pay.
• Where some APRs are fixed for the life of a loan, others are variable, meaning they fluctuate over time based on market conditions.
• This article will cover the annual percentage rate (APR) formula, how it is calculated, different types, and how you can get a better APR when you borrow money.

What Is APR?

Whether you're shopping for a small business loan or you're wondering where to borrow money for a major purchase, you'll want to understand the APR definition and how this term impacts your total borrowing costs.

• Annual percentage rate (APR) is represented as a percentage. APR is expressed as a percentage just as interest rates are. For example, you might see that a specific credit card product charges a variable APR of 21.99% to 28.99%.
• APR may be different from interest rates. Note that APR takes a financial product's interest rate into account, as well as required fees that consumers cannot avoid (e.g. annual fees).
• These rates can also be the same. When a loan is free of fees and all financing charges are based on the interest rate, the interest rate and the APR can be one and the same.

Fixed APR vs. Variable APR

There are scenarios where you can lock in a fixed interest rate that does not change over time, but you'll also find financial products with rates that go up and down based on market conditions. 

• Fixed APR: This type of APR does not fluctuate over time, and it's common with mortgages, personal loans, auto loans and other long-term financial products.
• Variable APR: This type of APR changes over time based on economic conditions and corresponding index fluctuations, and it's commonly found on credit cards and lines of credit.
• Which is better? There may be scenarios where a fixed APR can leave you better off, yet having a variable APR can pay off when interest rates are on the downturn.
• Better credit gets you a lower APR. Whether you are considering products with a fixed APR or a variable APR, having a good credit score can help you secure rates on the lower end of the scale.

How Is APR Calculated? 

The following APR formula can help you determine the APR of a financial product based on its interest rates and fees:

((Interest + Fees/Loan Amount) / Number of Days in Loan Term x 365) x 100

Other details to understand about APR include:

• Interest rates fluctuate based on key decisions by the Fed. The Fed sets a key interest rate called the federal funds rate, which is the rate banks pay to borrow money from each other. 
• The federal funds rate impacts consumers, too. Ultimately, this rate impacts how much interest consumers pay when they borrow money with credit cards and loans since the Fed's rate is the basis for the "prime rate."
• Lenders are legally required to list an APR for their financial products. The Truth in Lending Act (TILA) mandates lenders present you with an APR that shows the total costs of borrowing money.
• A few online tools can help you determine APR for financial products you're considering. This APR Calculator can help you figure out the total costs of borrowing based on interest rates, loan fees, and the loan amount.

Types of APR 

Where loans typically come with a single APR that's charged on the amount of money borrowed, credit cards and lines of credit can have many different APRs. Here's an overview of the different types of APRs you'll find today:

• Balance transfer APR: A balance transfer APR applies to balances transferred from other credit cards and loans, and it is typically only applicable for a specific length of time.
• Cash advance APR: This APR applies to cash advance amounts cardholders access when they use their credit card at an ATM or utilize credit convenience checks.
• Introductory APR: This type of APR is offered for purchases, balance transfers or both for a limited time, and is followed by the regular variable APR. 
• Penalty APR: This APR type applies when consumers pay their credit card bill after it's due date, thus it's higher than the regular APR for purchases.
• Purchase APR: This APR applies to purchases made with a credit card.

APR and APY: What's the Difference?

In addition to the annual percentage rate (APR), you've likely noticed that some financial products list something called annual percentage yield (APY) instead. While APR and annual percentage yield (APY) are both measures of interest, the way they work is dramatically different.

• APR is the interest you pay. Like we have explained already, annual percentage rate (APR) describes the total cost of borrowing money with a specific financial product.
• APY is the interest you earn. Meanwhile, APY represents how much interest you earn on financial products such as high-yield savings accounts and investments.
• APY takes compound interest into account. Because APY is interest you earn over time, it takes compounding interest (or interest earned on interest) into account.

Why APR Matters

APR matters because it directly impacts how much you'll pay to borrow money with a credit card or a loan. The higher the APR you get when you apply for financing, the more you'll pay in interest charges over time.

APR example

Imagine you want to borrow $10,000 with an excellent credit score and you hope to pay back the money over 60 months. If you were able to qualify for an APR of 8%, your monthly payment would be $202.76, and your total loan costs would be $12,165.84 (including $2,165.84 in interest payments).

Now imagine you have imperfect credit and can only get a loan with a 19% APR. In that case, borrowing the same $10,000 would leave you with a monthly payment of $259.41 for 60 months. Over that time, you would pay total loan costs of $15,564.33 and 5,564.33 in interest payments alone.

What is Considered a Good APR?

A good APR varies based on the financial product you apply for, whether that's small business equipment financing, an auto loan, a personal loan, or a line of credit or a credit card. Also be aware that a good interest rate can be different from one year to the next across all products since market rates fluctuate based on economic conditions.

The chart below shows what a "good" APR looks like right now across different financing options:

How to Get a Better APR 

APRs are always subject to market conditions, meaning some of the factors that impact your rates are beyond your control. That said, lenders also consider other factors, such as borrowers’ creditworthiness and ability to repay. 

The following tips can help you get a lower APR the next time you borrow money:

• Shop around and compare APRs: The best way to get a lower APR involves shopping around to compare loan offers from different lenders.
• Work on improving your credit score: Make moves that can boost your credit score in a hurry, including paying all bills on time and paying down debt to lower your credit utilization ratio.
• Choose a shorter loan term: Some loans offer lower rates for shorter terms. As an example, you'll pay a lower APR on a 15-year, fixed rate mortgage than you will on a 30-year home loan.
• Make a bigger down payment (mortgage, auto loan): A larger down payment on certain types of loans can help you score a lower APR and a lower monthly payment.
• Pay down your balance and negotiate for a better APR (credit card): Call your credit card company to negotiate your rate. The worst they can say is "no."

Can Your APR Change Over Time?

If you're wondering whether your rate can fluctuate over time, that really depends on the type of financing you applied for.

• Fixed APRs never change. If you borrowed money with a fixed APR, your interest charges and monthly payment cannot change over the life of the loan. 
• Variable APRs can (and do) change over time. Variable APRs can lead to higher loan costs when interest rates surge, yet they can also lead to savings when interest rates go down.

Final Word

Understanding what an annual percentage rate (APR) is and isn't can help you find the right loan products for your needs while saving money along the way. Generally speaking, you'll want to go with the loan product that offers the lowest interest rate, loan fees and APR in the end.

If you can't quite qualify for the lowest APRs available today, you should look into ways to increase your credit score over the long-term. By taking a few simple steps and waiting it out, you'll eventually qualify for business loans, credit cards, and more with the lowest APR you can find.