What Is an APR and How Does It Work?

What Is an Annual Percentage Rate (APR)?

A loan's APR is its interest rate plus any additional fees the lender charges, such as an upfront origination fee and other finance charges, represented as an annualized rate. Combining eligible fees and interest costs into one rate can give you a better idea of the annual cost of your loan.

When a lender includes fees in its APR calculation, it'll be higher than the loan's interest rate. However, in cases where there are no additional fees—or there are fees that aren't included in the APR, such as a credit card annual fee—the interest rate and APR are the same.

Depending on the type of loan you have, you may have a fixed or a variable APR. Here's how they differ:

• Fixed APR: As its name suggests, a fixed APR remains the same for the life of the loan, providing predictable monthly payments.
• Variable APR: With a variable APR, your rate is partially based on a market benchmark, such as the prime rate. As a result, your APR can fluctuate over time according to various economic conditions.

Types of APRs

With an installment loan, you may get either a fixed or variable APR. When you open a credit card, however, there are several other types of APRs that could apply to you depending on how you use your card. Here's how each type works:

• Purchase APR: This is the rate that applies to purchases you make with a credit card.
• Balance transfer APR: If you transfer a balance from one credit card to another, you'll pay the balance transfer APR on that portion of your balance. That said, it's usually the same as the purchase APR.
• Promotional or introductory APR: Some credit cards offer an introductory low or 0% APR on purchases or balance transfers for a number of months to incentivize you to open an account.
• Cash advance APR: When you use your credit card to withdraw cash from an ATM, the cash advance APR will apply to the amount you withdraw. A cash advance APR is typically higher than the purchase APR, and there's no grace period for interest charges.
• Penalty APR: Many credit card agreements include a higher penalty APR that the company will charge if you fall behind on payments by 60 days or more. The higher rate will remain in place for a minimum of six months.

APR vs. APY

Annual percentage yield (APY) is another term that sounds similar to APR, but the two are very different.

More specifically, the term APY is an annualized percentage that represents how much interest you'll earn, or yield, on a deposit account, such as a high-yield savings account, certificate of deposit or interest-bearing checking account.

Rather than incorporating fees associated with the deposit account, the APY accounts for compound interest you might earn.

APR vs. APY Example

Let's say you take out a personal loan of $15,000 with a 10% interest rate, a 5% origination fee and a three-year repayment term. Your loan's APR would be 13.39% (your interest charged plus the 5% origination fee, averaged over the life of your loan). Your total costs, including both interest and the upfront fee, will be $3,174.28.

On the flip side, let's say you put $15,000 in a three-year certificate of deposit with a 5% interest rate that compounds monthly. Your APY will be 5.116%, and your total interest earnings will be $2,422.08.

What Factors Impact Your APR?

There are various factors that influence your APR, some of which you can control and others you can't.

Loan Type and Lender

Some loans naturally charge higher APRs than others. With a mortgage loan or auto loan, for instance, APRs are typically lower because you're using the home or car you're buying as collateral to secure the loan, which reduces the risk to the lender.

In contrast, personal loans, credit cards and other unsecured loans typically charge higher APRs.

You may also notice when comparing a certain type of loan that different lenders offer different rates. Each lender has its own criteria for evaluating creditworthiness and determining interest rates and fees, which is why it's crucial that you shop around before applying for a loan.

Creditworthiness

Borrowers with less-than-stellar credit profiles are statistically more likely to default on their debts, so a lender may charge a higher APR to compensate for that risk.

In addition to your credit score, lenders will also consider your credit history and income. In particular, lenders look at your debt-to-income ratio (DTI)—the percentage of your gross monthly income that goes toward debt payments—to determine whether you can afford to take on more debt. A high DTI may result in a higher APR or denial of your application.

With secured loans, such as auto and mortgage loans, they may also consider your collateral and down payment.

Fees and Other Charges

If a lender charges fees on top of your interest rate, they may be included in the APR, causing it to increase. Note, too, that some fees may not be included in your APR calculation. Ask your lender for a breakdown to make sure you fully understand your costs.

Benchmark Rates

Lenders use different benchmark indexes to calculate the rates they offer to borrowers. One example is the prime rate, which is directly influenced by the Federal Reserve's federal funds rate.

The prime rate can impact the rate you'll get when you apply for new loans, but it won't impact your open accounts unless the APR is variable.

How Is APR Calculated?

In many cases, the rate lenders advertise is the APR, so you don't have to do any math to get the full picture of your costs. However, some loans may simply charge a fee instead of interest, and the APR isn't always easy to find.

In this case, you can use an online APR calculator or run the numbers on your own. If you prefer to do the math, here's the formula you'd use:

APR = (((Interest charges + fees / loan amount) / Number of days in the loan term) x 365) x 100

Example: Let's say you borrow $10,000 with a 12% interest rate, a 5% origination fee and a three-year repayment term. Here's how you'd calculate the loan's APR using the above formula:

1. Multiply $10,000 by 0.12 and then 3, giving you interest charges of $3,600
2. Multiply $10,000 by 0.05, giving you an origination fee of $500
3. Divide interest and fees of $4,100 by $10,000, giving you 0.41
4. Divide 0.41 by 1095 (the number of days in your loan term), for a result of 0.000374429223744
5. Multiply 0.000374429223744 by 365, giving you an APR of 0.136666666666667
6. Multiply that by 100 to convert the APR to a percentage of 13.67%

APR calculator

Frequently Asked Questions

Improve Your Credit to Qualify for Lower Rates

Lenders consider more than just your credit score when determining your APR on a loan or a credit card. But the better your credit history looks, the higher your chances of scoring favorable terms.

You can check your credit scores to see where you stand and pinpoint areas that may need some work. Also, get a copy of your credit report to check for errors and items that may need to be addressed.

As you work on improving your credit, it's no guarantee you'll get the best APRs possible, but it will give you the opportunity to get a lower rate than what you currently qualify for, which can save you a lot of money in the long run.