Melissa is a Midwesterner with a penchant for travel (the further away, the better!). She's the Money Editor at Benzinga and likes to write about personal finance and entrepreneurship.
You’re on the hunt for a house, a car, a student loan, credit card or something even more exciting like a motorcycle or an RV. Whatever it is, you know you need to borrow for it. Whatever you plan to purchase, you check it out, smell the fresh leather interior, analyze the price tag and find out how much it’ll cost to pay it back. The interest rate sounds good — excellent, even. You’re ready to sign on the dotted line.
But hold up! Are you actually ready to sign? Or do you need to ask a few more questions about those pesky interest rates first? You just might need to do some detective work. Here’s what you need to know about the elusive sneakster, annual percentage rate, or APR.Wealthsimple Invest is an automated way to grow your money like the worlds most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.
What is Annual Percentage Rate (APR)?
APR is the amount it costs you to borrow money. But did you know that it’s more than just the interest rate?
Annual percentage rate also includes fees you may be required to pay to take out a loan. It includes the interest rate, plus other costs, too — such as lender fees, closing costs and insurance.
You may hear about a couple of different types of APR: Fixed-rate APR (or fixed APR) and variable-rate APR (or variable APR).
A fixed-rate APR sets an APR that does not fluctuate with changes to an index, according to the Consumer Financial Protection Bureau. This doesn’t mean an interest rate will never change. It actually means that an issuer must alert you before an interest rate will change.
A variable-rate APR, on the other hand, changes with the index interest rate, such as the prime rate published in the “Wall Street Journal.” The cardholder agreement will say how a card’s APR can change over time.
Call-Out Box: APR Definition: APR is a yearly interest rate that includes extra fees and costs paid to obtain the loan. Lenders are required to disclose the APR. The rate is calculated taking the average compound interest rate over the loan term, so borrowers can compare loans. APR gives you a better idea of what you’ll actually pay.
Interest rate vs. APR
Even though you now know there’s a difference between interest rate and APR, you still might be eager to lump the two together. It just seems too complicated, right? The esoteric jumble of letters should be just shoved into the same messy slushpile. But it could cost you a lot of money in the long run if you don’t understand the difference. Do your detective work before you make a decision on a loan. In fact, check both the interest rate and the APR as you consider taking out a loan.
For example, let’s say you’re buying a home for $100,000. Your interest rate is 5%. This means that at the beginning of your loan, your mortgage builds 5% in interest every year. That’s $5,000 annually, or about $416.67 per month. The APR includes your interest rate as well as any prepaid interest, private mortgage insurance (PMI) or other fees you need to pay. Your APR will reflect a higher number than your interest rate.
And when you’re shopping for loans, remember to always compare APRs — not interest rates — because the APR is the rate that you’ll actually pay. Here are a few interest-related definitions that we’ll lay out side-by-side so you recognize the difference:
Interest rate: The amount charged as interest for a loan, typically expressed as an annual percentage of the outstanding loan.
Annual percentage rate (APR): The rate you pay on a loan for a year, plus the costs associated with the loan.
Annual interest rate (AIR): AIR is the average amount of interest, which is expressed as a percentage, that you pay on a loan each year. It’s easy to calculate. Divide the total interest amount by the loan amount and the number of years you borrow the money. For example, let’s say you borrow $100,000 for one year. Let’s say the total interest cost is $5,000. The figure would look like this: $5,000 / ($100,000 / 1) = 5% AIR.
Annual percentage yield (APY) or effective annual rate (EAR): APR doesn’t take compounding into account, but APY, or its twin, EAR, does — it adds in the frequency with which interest is applied, or the effects of compounding within the year.
Call-Out Box: APR is not the same thing as annual percentage yield (APY), or effective annual rate (EAR). APY and EAR take compounding into account — it’s the interest rate adjusted for compounding over a given period. It’s how much you can earn (or pay) in a year after taking compounding into consideration. Here’s the effective annual interest rate (EAR) formula:
EAR = Effective annual interest rate = (1 + (nominal rate / number of compounding periods)) ^ (number of compounding periods) - 1
What is a good APR?
What’s a good APR, anyway? Great question. But first, how does a lending institution determine what your rate will be? (The great questions just keep flowing, don’t they?)
The institution evaluates several factors related to your personal situation — some things you have no control over. (Hint: You have no control over the prime rate). Your APR also depends on what type of loan you’re getting. APR rates depend on a few factors, though this isn’t an exhaustive list:
Prime rate: The prime rate is the interest rate that banks charge their ideal customers. It’s closely tied to the federal funds rate. The federal funds rate is what Federal Reserve banks charge each other for short-term loans.
Credit: How have you done with credit in the past? Lending institutions look at your financial situation to determine your APR — and that includes your credit score. Generally, the higher your FICO credit score, the lower your interest rate will be. FICO scores are broken down into the following ranges:
Exceptional: 800 to 850
Very good: 740 to 799
Good: 670 to 739
Fair: 580 to 669
Poor: 300 to 579
Size of your down payment: You can reduce your APR if you put down a larger down payment.
Length of the loan: In general, the shorter the loan term, the lower your APR will be. A 30-year loan term will usually carry a higher APR than a 15-year loan term.
Income and job history: A lender’s job (specifically, underwriters for a lender) is to assess your risk. If you look like a risky candidate for a loan — for example, you may have inconsistent income on a month-to-month basis. If you’re not outright denied for a loan, you’ll be charged a higher APR.
Now, you might be wondering whether the rates you’re offered from lenders are competitive. Let’s take credit cards into consideration in this example. The average credit card APR is 15.09%, according to the Federal Reserve. However, did you know that the type of credit card you choose can make a difference in your APR? (Rewards credit cards’ APR is a tiny bit higher because they offer more to consumers.)
It’s tough to go through every loan possible, so here are two good APRs to keep top of mind:
The average APR for rewards cards, such as cashback and travel cards, ranges between 17.13% and 24.63%, according to U.S. News research. In short, an APR below 17.50% is a good APR for a credit card.
A good rate for a personal loan is one that’s lower than the national average of 9.41%, according to the most recently available Experian data.
Canada loan agreements are legally required to display the APR — not just the interest rate. In fact, the legal limit for Canadians is at most, 60% APR, including fees and charges.
Note: The payday loan industry is regulated by province and has different legal limits.
A payday loan allows you to borrow an amount of money you must repay by your next payday, over a two-week period. Payday lenders charge exorbitantly high interest rates and fees.
How to calculate APR
Calculating the APR of a loan is simple. You just need three numbers: the amount borrowed, the total finance charge, and the term length of the loan.
Divide the finance charge by the loan amount.
Multiply the result by the number of days in the year.
Divide that total by the term of the loan in days.
Multiply the result by 100 and add a percentage sign.
Example of APR
Let’s say you take out a $20,000 boat loan for 1 year with a $1,000 finance charge. (You’re just trying to keep the math simple.) Using the formula above, you’d calculate:
$1,000 / $20,000 x 365 / 365 x 100 = 5%
Be a Smart Consumer
Remember, always borrow within your means, pay back your loan on time (that means on its due date!) and if you can, pay ahead. You can find so many credit opportunities and they all have different costs, features and disadvantages. Know before you borrow:
The full cost of the loan, including the interest you will pay.
Understand any fees or penalties.
Whether you have the lowest APR — not just the lowest interest rate!
Keep the costs of borrowing to a level you can handle for best results, and don’t be afraid to be a great detective and ask lots of questions in the process.
A good investment strategy is an essential part of a strong financial plan. Wealthsimple can help you with that. Want to learn more? Check out Benzinga’s Wealthsimple review.