Are you planning to get a loan or open a new credit card? You know you typically can’t borrow money for free.
APR (annual percentage rate) indicates how much it costs to borrow money over the course of one year. To understand all the potential costs associated with loans and credit cards, you need to know the APR and what it means before you borrow so you can get the most complete picture of what you’ll end up paying.
What is APR?
In simple terms, APR indicates how much it will cost you to borrow money. APR for open-end credit, like a credit card, is calculated differently than APR on closed-end credit, like a mortgage (more on that below).
Compared to the interest rate, APR gives you a more complete picture of the true cost of borrowing. Federal regulations require that APRs be disclosed to you in writing before you are legally bound to pay the loan.
You’ll see APRs disclosed on all types of credit accounts, including:
- Auto loans
- Mortgage loans
- Home equity loans
- Credit cards
- Personal loans
An APR can be fixed, meaning it stays the same for the life of the loan, or variable. Variable APRs are tied to an index rate; if that index rate goes up or down, your APR follows suit. Variable APRs are more often associated with credit cards, while loans typically have fixed APRs.
It’s important to note that APR is different from APY (annual percentage yield), so double-check to know which number you’re looking at. Learn more about the difference between APY and APR.
What determines APR?
Your credit score comes into play when lenders determine a given APR. A higher credit score typically translates to a lower interest rate from the lender, which means a better APR and, potentially, a lower cost of borrowing for you.
For closed-end credit, like a mortgage, the amount of fees your lender charges is another thing that determines where your APR ends up. Fewer fees can mean a lower APR.
How is APR calculated?
APR is calculated differently depending on the type of credit issued. With a credit card, for example, the issuer starts with an index, like the U.S. prime rate. Then the issuer adds a margin, which is a set number of percentage points, to that index. The margin is usually based on your credit score. The higher your credit score, the lower the margin, and vice versa.
As the example below illustrates, if the index were 3.75 percent, and your issuer adds a margin of 10 percent, your credit card’s APR would be 13.75 percent.
With mortgage loans, car loans, and personal loans, your APR is determined by your interest rate, the loan repayment term, and your closing costs. Say you get a $200,000 home loan with a 4.50 percent interest rate and a 30-year loan term. You pay $4,800 in closing costs. In that scenario, your APR would work out to 4.70 percent.
APR and closed-end credit
For a closed-end loan, like a mortgage, APR includes your interest rate, points, fees, and other charges the lender includes over the course of one year. For that reason, the APR on a loan is usually higher than the interest rate.
For example, the APR on your mortgage includes the interest rate on the loan principal, but it can also cover discount points, mortgage insurance, broker fees, or closing costs that are rolled into your loan.
Compared to the interest rate, APR gives you a more complete picture of the true cost of borrowing. The lower the APR on your loan, the less money it will cost you overall in interest and fees while you pay the balance off.
APR and open-end credit
Although it’s common, using the term “interest rate” for credit cards isn’t entirely accurate. For a credit card, the APR is the rate advertised, then any fees or other charges are calculated and disclosed separately.
Interest and fees for credit cards can change depending on how you use the account. For example, your credit card might have one APR that applies to purchases, one for cash advances, one for balance transfers, and so on. And that’s not including the fees that apply to things like late payments or annual renewal.
So how does APR impact your loan account?
The higher the APR, the more you’ll pay in interest to borrow a given amount. If you’re planning to get a loan or open a credit card, do your homework and compare APRs from different lenders. Shopping around can help you find the best APR for your borrowing needs. Understanding how APR works will go a long way in helping you make sure you don’t pay too much for your credit.