You’re not alone if you’ve ever wondered how APR works. 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, and what it includes/does not include.
What does APR mean?
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.
Generally speaking, the lower the APR, the better.
How does APR work?
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.” For a mortgage, this may be referred to as an ‘origination fee.’
- Underwriting fees. The underwriter reviews your loan application and makes a final decision.
- Document fees. These usually pertain to drawing up documents for the loan that you’ll eventually sign.
- Appraisal fees (mortgage loans). This is a fee for someone to come out and place a value on the home.
The cool thing about an APR is that it gives you a really easy way to compare loan rates.
APR vs. interest rate
APR 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 APR 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 your lender to provide both.
Variable APR vs. fixed APR
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%, your variable APR might be noted as 8.00% + Prime Rate, or 11.5%. The rate is considered variable because it can change — in this case, depending on what the Prime Rate does.
Fixed APR
A fixed APR is just the opposite. While it’s not completely guaranteed to never change, it’s certainly more stable than a variable APR.
A fixed APR doesn’t use a reference rate at all, and instead it’s a rate determined by your lender. The rate is usually determined by 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 fixed rate can still change if certain things happen — e.g., 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 fixed rate can change.
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 APR 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.
What is a good APR?
The best APR you’ll get depends on a few factors:
- The type of credit you’re using (such as a credit card, a car loan, or a personal loan)
- Your credit score. If you have good credit, you’ll qualify for lower APRs.
- The prime rate
What is a good APR for a credit card?
Average credit card APRs change based on the prime interest rate. According to the Federal Reserve, the average APR for all credit cards as of August 2022 was 16.27%.
In general, any credit card APR in the low teens — say 15% or below — is pretty good. Some cards may offer APRs in the 10% range, but those are rare.
What is a good APR for a car?
Car loan APRs also vary based on credit. A good APR for a car, for good-credit and fair-credit borrowers, is anything below 5%. The average 60-month APR for August 2022 was 5.50% per the Federal Reserve.
Borrowers with excellent credit can get APRs as low as 2.47% for new vehicle loans and 3.61% for used vehicle loans. For more middling but good credit ranges, the average is 3.51% for new vehicles and 5.38% for used vehicles.
Read more: Best auto loan rates in 2022
What is a good APR for a loan?
Typical APRs for personal loans fall within a wide range. The August 2022 average for a 24-month personal loan APR was 10.16%.
Excellent-credit borrowers can potentially get APRs below 8%. But on the whole, any APR in the 10% range is pretty good. On the high end, personal loan APRs can run up to 36% for subprime borrowers.
Credit card APR: What are the three different rates?
A credit card is a little different than most loans, in that it places your purchases in categories, each with a corresponding APR. Typically there are three categories: purchases, balance transfers, and cash advances.
The three rates are usually different, and you’ll see that on your credit card statement.
Purchase APR
A purchase APR is the interest rate you’re charged on credit card purchases when you carry a balance on your credit card. This is the most common kind of credit card APR that’s charged.
Read more: Best low-interest credit cards
Balance transfer APR
A balance transfer APR applies to any debt transferred from one credit card account to another. It may be higher or lower than the purchase APR.
A lot of cards offer balance transfer promotions for new customers when they open credit cards. These introductory offers give you a 0% or low APR on balance transfers for a limited time (usually anywhere from six to 18 months). If you don’t pay off the full transferred balance by then, the regular balance transfer rate will kick in.
Cash advance APR
A cash advance APR is the interest rate you’re charged on any cash you take out from a credit card account (e.g., you use your credit card to withdraw cash from an ATM).
These APRs usually range from 25% to 30%, far higher than typical purchase and balance transfer APRs.
Interest on cash advance APRs starts accumulating as soon as you withdraw cash. In other words, there’s no grace period — unlike with purchase APRs, where interest doesn’t start building until the end of the billing cycle.
An example of how credit card APRs work
Let’s say you open a credit card and immediately do a $5,000 balance transfer at 0% interest (just remember, it’s not really 0% because you’re paying a transaction fee).
After that, you make $1,000 in purchases that month, at 16.99%.
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 it’s 25.99%.
When the first credit card 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 the three different APRs:
- Balance transfers (0%): $5,000
- Purchases (16.99%): $1,000
- Cash advances (25.99%): $500
So, if you make a payment on your credit card, which APR is that payment 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 25.99% would sit there and collect interest while you made aggressive payments toward the 0% balance, then the 16.99% balance (after the 0% balance was paid off in full).
Sound crazy? It was. I experienced it firsthand 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% cash advance off immediately.
How to calculate APR
Here’s how to calculate the daily APR you’re paying on a credit card.
Find the daily rate
Divide the APR you’re getting on your card by 365, the number of days in the year. This will give you your daily rate, also known as the daily periodic rate. Use decimals when you’re making this calculation. For a 17% APR, for instance, use 0.17 / 365 = about 0.00046.
Factor in your balance
Multiply the daily rate by your current balance. Let’s say you have a balance of $500 on that 17% APR card. Take your daily rate of 0.00046 and then multiply this number by 500. You’re incurring an average daily APR charge of $0.23.
Look at APR for the whole month
Multiply your daily APR charge by the average number of days in a month (30.44). Using the above example: $0.23 * 30.44 = about $7 you’re paying in interest monthly.
Summary
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 out any credit product.
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 in making a smart decision as a borrower.
