You’re not alone if you’ve ever asked “How does APR work?”. The APR, or annual percentage rate, of a loan can be much more complex than just a simple interest rate.
In this article, I’ll answer some common questions about the annual percentage rate, including how it works, what it includes and does not include
What is an APR?
APR, or annual percentage rate, is the interest rate you pay on a loan—such as a credit card or auto loan—on a yearly basis. In simple terms, it’s the cost of borrowing the money.
Your APR is shown as a percentage and includes fees and costs related to the loan. These fees and costs will vary depending on the type of product you’re applying for (i.e. home loan, auto loan, etc.), but here are a few examples of fees that are usually included in the APR:
- Processing fees—banks will lump all kinds of things into “processing fees” so be sure to ask what this is for.
- Underwriting fees—the underwriter is who reviews your loan application and makes a final decision.
- Document fees—usually pertaining to drawing up documents for the loan that you’ll eventually sign.
- Appraisal fees (mortgage loans)—a fee for someone to come out and place a value on the home.
- Origination fees (mortgage loans)—often confused with processing fees, but sometimes they’re the same. Ask about it.
For most loans other than mortgages, the fees associated usually pertain to processing and managing the loan. The annual percentage rate doesn’t include compounding, which is discussed more below.
The cool thing about an APR is that it gives you a really easy way to compare loan rates. For example, a product like a credit card comes with all types of fees and costs associated with the account.
Seeing as all credit cards are different, the annual percentage rate gives you a quick and easy way to compare cards.
This also applies to other types of loans. Generally speaking, the lower the APR, the better.
What is the difference between the APR and the interest rate?
The annual percentage rate includes costs and fees associated with the loan. The interest rate does not. The interest rate is simply the rate you pay on the loan, excluding any other costs.
Looking at the interest rate alone is not an effective way to evaluate a loan. The annual percentage rate is much more effective, as it uses the interest rate and rolls in any other costs to finance the loan, providing a much more holistic view.
When you apply for a loan, you should always be able to see both the interest rate and the APR.
If you don’t, ask.
What is the effective APR?
The effective annual percentage rate (sometimes referred to as the annual equivalent rate) is the most efficient way of looking at a loan, because it includes the interest rate, costs associated with financing the loan, and compounding interest (discussed below).
This isn’t always shown, because it often depends on things like the amount of your monthly payment, as well as whether there are penalties for paying the loan off early, and whether it’s a variable rate.
This isn’t to be confused with the effective interest rate, which doesn’t include fees associated with the loan (like the example above).
What is compounding interest?
Compounding interest is the interest you’ll pay not only on the principal balance of your loan, but on the interest of your loan. Yes, you pay interest on your interest.
Confused? Let me explain.
Let’s say you take a $10,000 loan at a 5 percent interest rate (we’ll use interest rate, not APR, for simplicity). We’ll also assume that the loan compounds monthly (you’ll want to know the compounding periods per year—it’s usually daily, monthly, or annually).
Each month, you’ll be charged 1/12 of that 5 percent interest rate (5 percent divided over 12 months):
5.00 percent / 12 = 0.42 percent
So after the first month, your balance is still $10,000 (it’s a new loan) and the bank is ready to charge you interest on that balance:
$10,000 x 0.42 percent = $42
You’ll pay $42 in interest, bringing your new balance to $10,042. Not including payments, interest will now build off of the $10,042—not the original $10,000.
(This is the essence of why we suggest paying off your credit card debt as quickly as possible. By making small payments, compounding interest could take over and you will end up paying more than you ever intended.)
Is a lower APR always better?
In most cases, a lower APR is better, but not always. A great example of when a lower APR might not be your best bet is with a mortgage loan.
If you recall, the annual percentage rate is basically [interest rate + the cost of financing the loan]. With some mortgage loans, you’ll get a lower overall APR, but you may have to pay higher points, closing costs, or other fees associated with closing your home loan.
When you’re applying for a mortgage, or any loan for that matter, be sure to read all the fine print and ask your loan originator for as many details as you can. Sometimes what looks best on paper isn’t what’s best for your pocket.
Why do credit cards have different APRs?
Credit cards will show different APRs on your bill to show how you have used the credit card, and the corresponding APR to that particular use. Typically there are three categories: balance transfers, purchases, and cash advances.
A credit card is a little different than most loans, in that it places your purchases in “buckets,” each with a corresponding APR. Sometimes they are all the same, but more often than not they’re different, and you’ll see that on your credit card statement.
Here’s an example. Let’s say you open a credit card and immediately do a $5,000 balance transfer at 0 percent interest (just remember, it’s not really 0 percent because you’re paying a transaction fee). This would be in its own category, probably “balance transfers.”
After that, you make $1,000 in purchases that month. The interest rate on purchases might be 11.99 percent. Again, this will go in its own category, probably called “purchases.”
Finally, say you were in a bind one day and had to use the credit card to take $500 cash out of an ATM (which we strongly discourage). This is typically the highest APR, so we’ll say its 22.99 percent. This goes into the “cash advances” category on your bill.
So when you signed up for the card, you may have seen the interest rate advertised as 11.99 percent, with a 0 percent promotional offer. Typically banks will show you the purchase rate, since that’s the most common use of a credit card, then any promotional rates (or vice versa). They don’t advertise the rate on cash advances because it’s so high.
Using our example above, when the first bill comes (no interest has accumulated yet), you’ll have a new balance of $6,500 (not including fees). Yet it’ll be broken down into three different APRs:
Balance Transfers (0 percent): $5,000
Purchases (11.99 percent): $1,000
Cash Advances (22.99 percent): $500
When I make a payment on my credit card, which APR does my payment get applied to first?
Prior to 2009, when you made a payment on your credit card, it would go to the lowest APR first. Doesn’t make any sense, right?
This was how banks made a killing off of their customers. Essentially, they’d be able to trap their customers into paying higher rates, and consumers couldn’t pay off a higher APR until they had paid off all other balances first.
Using our example above, this means that $500 at 22.99 percent would sit there and collect interest while you made aggressive payments toward the 0 percent balance, then the 11.99 percent balance (after the 0 percent balance was paid off in full).
Sound crazy? It was. I experienced it first hand working for a Fortune 500 bank at the time.
Thankfully, the Credit CARD Act of 2009 came around and put a stop to this nonsense. Now when you make a payment to your credit card, it gets allocated to the highest APR first. So you can pay that 22.99 percent cash advance off immediately.
What’s the difference between a variable APR and a non-variable APR?
A variable APR is determined by using a base (or reference) rate and adding a certain percentage—known as the margin—to that base. A great example of a reference rate would be the Prime Rate.
If the Prime Rate is 3.5 percent, your variable APR might be noted as 8.00 percent + Prime Rate, or 11.5 percent (8.00 + 3.5 = 11.5 percent). The rate is considered variable because it can change—in this case, depending on what the Prime Rate does.
A non-variable APR is just the opposite. While it’s not completely guaranteed to never change, it’s certainly more stable than a variable APR.
A non-variable APR doesn’t use a reference rate at all, and instead it’s a rate determined by your lender. The rate is usually determined primarily off of your credit score, but some loans and credit cards won’t go lower than the minimum rate the bank has determined it’ll offer for that product.
Keep in mind, a non-variable rate can still change if certain things happen—you’re late on your payment or stop paying completely. Make sure to read the terms and conditions of your loan so you know if and when a non-variable rate can change.
While the APR is a quick and dirty way of evaluating and comparing loan products, it shouldn’t be the only thing you look at. Use it as a point of reference and do as much research as you possibly can before agreeing to take a loan.
There are plenty of other factors to consider besides APR, such as the monthly payment, the credibility of the institution loaning you the funds, and whether they offer online banking or an app for you to use on the go. In other words, knowing the APR is just the first step.