What is APR and how does it work?
- Feb 28, 2023
- 5 min read
What we'll cover
What APR is
How it’s calculated
The different types of APR
Whenever you get a new loan or credit card, you probably know you’re not just paying for the cost of purchases. The annual percentage rate, or APR, indicates how much it costs to borrow money over the course of one year.
What is APR?
You are probably familiar with the term interest rate, which is the amount a lender charges a borrower, and is a percentage of the principal amount of the loan. APR, on the other hand, gives you a more complete picture of the true cost of borrowing compared to just looking at the interest rate. APR includes the interest rate as well as other costs of borrowing, such as lender fees, closing costs and insurance.
Federal regulations require that APRs be disclosed to you in writing before you are legally bound to pay the loan.
You will see APRs disclosed on all types of accounts, including:
Home equity loans
APR can be fixed, meaning it stays the same for the life of the loan, or variable, which means it’s 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 annual percentage yield, or APY, so double-check to know which number you’re looking at.
How does APR work?
The higher the APR, the more you’ll pay 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.
In general, credit cards offer a grace period for new purchases, meaning if you pay off your ending balance by the monthly due date, you will only pay the amount of the purchase without any interest added. But if you carry a balance, the interest rate will apply, and you’ll be charged based on the APR.
With installment loans such as mortgages and personal loans, you will pay interest based on the APR (unless you pay down the principal in advance).
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 5.50 percent, and your issuer adds a margin of 10 percent, your credit card’s APR would be 15.50 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.
Types of APRs
APR is calculated differently depending on if it’s for open-end or closed-end credit.
APR and closed-end credit
For a closed-end loan, like a mortgage, APR includes your interest rate, points, fees and other changes 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.
APR and open-end credit
Although it’s common, hearing the term “interest rate” 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. Take a closer look at the different types of APR for credit cards.
When you buy something on a credit card, the rate that’s applied is the purchase APR.
Cash advance APR
If you borrow cash from your credit card, you will be charged a separate cash advance APR, which is typically higher than purchase APR. Transactions such as purchasing lottery tickets, exchanging U.S. dollars for foreign currency and buying casino chips may also be considered cash advances.
When you violate a credit card’s terms and conditions (like failing to make payments on time), you may be charged a penalty APR, which is usually higher than either purchase or cash advance APR.
Introductory or promotional APR
A new credit card may come with an introductory or promotional APR, which is typically lower than the APR on the card after this initial period ends.
What impacts your APR?
Your credit score is a big factor in determining your APR. A higher credit score typically translates to 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 component that determines where your APR ends up. Fewer fees can mean lower APR.
How to get a lower-interest card
The best way to be approved for a credit card with a lower interest rate is to build and maintain a good credit score. You may also be able to negotiate a lower interest rate with the issuer. If you can get a competing offer with a lower interest rate than your current one, you can use this information as leverage. You might also want to look into a balance transfer, which allows you to transfer your current balance to a new card with either a low or no interest rate for a limited time.
Understand APR to make the most of your money
Borrowing money in the form of a credit card, mortgage or any other type of loan doesn’t come for free. But a lower APR means you will pay less total over the course of the borrowing period. Understand your options to get the best rate possible.
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