July 2, 2021
What we’ll cover:
We’re guessing if you’ve been thinking about applying for a loan or credit card, you’ve probably heard a term called “APR" right?
If so, you might be wondering what exactly "APR" is and why it matters.
You’ve come to the right place to learn more - below we'll dig into what APR is, different types of APR, how APR is calculated and more.
APR stands for Annual Percentage Rate, which is the total yearly cost of borrowing money expressed as a percentage of the loan amount. In simpler terms, APR is the price of borrowing money.
This annual rate includes the interest and other additional costs or fees associated with the loan. APR can be used as a number to help compare the total cost of one loan to another.
Here’s a little background:
The calculation and disclosure of APR has been governed by the Truth in Lending Act (TILA) since it was passed in 1968. TILA mandated that consumer lenders clearly provide the annual percentage rates on loans. Before the passage of this law, some lenders were vague about costs associated with borrowing from them.
TILA was designed to protect consumers and make it easier for borrowers to compare costs and loans fairly.
Now that we’ve covered what APR means and some of the background, let’s talk a little about how the APR actually works.
Whether we’re talking a mortgage, auto loan, or a credit card, lenders generally offer some kind of grace period for you to pay off new purchases without accruing any interest charges. So, if you always pay your bill in full and on time, APR might not be very relevant to you.
However, if you do carry a balance, the APR works by applying interest to your balance until its paid off. And those charges can add up quickly.
Particularly if we’re talking credit card interest – some credit cards can have high APRs. According to U.S. News in April 2021, the average credit card APR can be as low as 13% or as high as 26% and more.
How is APR different from interest rate? Excellent question – the two are often confused.
The interest rate is the amount a lender (a bank, for example) charges a borrower (you, for example) in return for lending money to that borrower. Interest rates are expressed as a percentage of the principal (e.g., 15%), usually in annual terms.
On the other hand, APR is the interest rate plus certain additional costs and fees that a lender may charge, resulting in the total annual cost of a loan. As a result, a loan’s APR may be higher than the interest rate, and it’s more comprehensive of the total cost you’ll be paying.
When you apply for a loan, it’s important to consider the APR and not just the interest rate.
There are a lot of opinions about what makes a good APR. For example, some people might find it worth paying a higher APR if they’re receiving credit card rewards or points. But if we use the Federal Reserve as a benchmark, since early 2018, the average interest rate has been about 14% to 15% APR.
Credit card APRs can vary depending on the issuer and type of card.
In most instances, your credit card APR is also largely affected by your creditworthiness and the prime interest rate, which is determined by the Federal Reserve.
Although the Fed’s prime interest rate is out of your control, having a better credit score can increase your chances of getting a lower APR (yet another reason to regularly monitor your credit reports).
Turning again to data from U.S. News, personal loan APRs in 2020 typically ranged from 4% to 36%, with an average of 12%. Similar to credit cards, having a better credit score could help you get a better rate.
If you can, pay off your credit card balance in full each month so you’re not affected by the Purchase APR and won’t pay extra money on interest.
Different types of credit also have different average APRs. Auto loans and home loans generally have lower APRs because they are secured. Unsecured credit cards and unsecured loans will generally have higher rates because they present greater risk for the lender.
Some APRs can be variable, meaning the APR can change throughout the life of your loan or credit card. Alternatively, other APRs can be “fixed” meaning they may stay the same or will generally only be changed with advanced notice.
Credit cards can have introductory APRs, purchase APRs, cash advance APRs and balance transfer APRs.
The specifics of your APR will always be laid out in the credit card’s terms and agreements.
If you can, pay off your credit card balance in full each month so you’re not affected by the purchase APR and won’t pay extra money on interest.
To calculate a loan APR, you’ll need to first calculate the monthly payment. To do this, you’ll need the loan’s principal amount, annual interest rate and any fees. We recommend calculating all of this in Excel using the PMT and RATE functions.
Here’s a real life example:
How to calculate monthly payment (PMT)
Here is what the monthly payment would be in our example:
How to calculate APR (RATE)
Here is what the monthly payment would be in our example:
If calculating APR triggers awful flashbacks to high school algebra, don’t worry. It’s highly unlikely you’ll ever need to calculate APR because lenders disclose this when you apply for a loan or credit card.
APR is the annual cost charged by a lender for borrowing money, expressed as a percentage of the loan amount. Costs may include interest, fees or other expenses associated with the loan.
APR is calculated as the sum of the applicable fees, expenses and interest over the life of the loan expressed as a percentage of the loan amount. The APR will be higher than the interest rate if fees or other costs are charged for the loan.
If there are no additional costs or fees, the APR should be equal to the interest rate.
The interest rate of a fixed APR loan won’t change during the term of the loan—though in some cases it could change if you default.
The interest rate of a variable APR loan, however, is typically based on an underlying benchmark interest rate that may go up or down. Given that, a variable APR loan can change as the underlying interest rate changes. Find out whether your APR is fixed or variable so you know if the rate will stay the same over the life of your loan.
Good to know: All other things being equal, when you are comparing loans, the loan that has the lowest APR is usually the least expensive option.
APR, as opposed to interest rate, helps you evaluate the true cost of your loan or credit card, since an interest rate may not reflect other fees and costs associated with the loan.
Don’t hesitate to ask your lender what costs and fees are included in your APR.
This article is for informational purposes only and is not a substitute for individualized professional advice. Articles on this site were commissioned and approved by Marcus by Goldman Sachs®, but may not reflect the institutional opinions of The Goldman Sachs Group, Inc., Goldman Sachs Bank USA or any of their affiliates, subsidiaries or divisions.
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