If you’ve ever taken out a credit card or a personal loan, you were probably introduced to a bunch of technical-sounding jargon. Phrases like “interest rate” and “APR” are common in the financial world.
But what do they actually mean? And just as importantly, how do you calculate your monthly APR and keep up-to-date on your finances?
What is APR?
APR stands for “annual percentage rate,” and it is a lender’s official rate for what it will cost you to borrow money over the course of a year. Your APR may vary depending on the type of loan, as well as the specific lender offering your loan.
Why is APR important?
Understanding APR is important because it details the actual price you pay to borrow money. A higher APR means that you’re paying more in fees and/or interest over the life of the loan.
Additionally, lenders are required to disclose their APR by the Truth in Lending Act (TILA) of 1968. As a result, borrowers can comparison shop for less expensive loans by comparing APRs.
How does APR work?
Lenders determine your APR based on a variety of factors. Having a high credit score and solid repayment history usually qualifies you for a lower APR. On the other hand, if your history shows that you can’t pay off your credit card debt or other loans, you may get a much higher APR.
Additionally, depending on the type of loan, the specific details of what your APR actually entails may differ.
For instance, many types of loans bundle both your interest rate and additional fees into your APR. Take your mortgage APR as a pristine example.
It may account for “points,” or fees paid to the lender to lower your interest rate. Some auto loans may include dealer compensation and extra fees.
By contrast, most credit cards offer a simpler APR. It is typically just the interest rate you pay on your monthly balance.
Variable vs fixed APR
There are two basic types of APR: fixed and variable.
A fixed APR doesn’t change; your rate will remain the same for the duration of the loan. Fixed APRs make budgeting simpler, as you know what you’ll pay in the long-term. Examples include most mortgages and federal student loans.
By contrast, a variable APR may fluctuate. Variable interest rates are tied to an index interest rate, such as the prime interest rate. When the index rate goes up or down, your variable APR will move, too. Typically, credit cards operate on variable APRs, as well as some mortgages.
What is the difference between APR and interest rate?
When it comes to credit cards, your APR and interest rate are usually the same thing. But with other types of loans, such as mortgages, your interest rate and your APR are not the same.
Your interest rate is a percentage of the loan principal—the money you receive—that a lender charges you to borrow money. By contrast, your APR includes the extra fees and costs of taking out the loan.
What is a good APR rate?
The definition of a “good” APR usually differs based on the type of loan you have. For instance, a good mortgage APR might fall between 2-3%, while a good credit card APR may be as high as 14-19%. This is yet another reason to avoid credit card interest whenever possible!
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Calculating APR in 6 easy steps
Though your lender is legally required to explain your APR upfront, the specifics may vary. Thus, it’s important to understand how to calculate your monthly APR before you start hunting for loans.
Step 1: Calculate your extra costs
The first step in calculating your APR is adding together any loan-related fees. These may include mortgage points, originating fees, or dealer compensation, depending on the loan.
Note that if you’re calculating the APR on a credit card, you may not have any fees, in which case you can skip this step.
Step 2: Add your costs and interest together
The second step is to add your total fees to the lifetime interest of your loan.
Step 3: Divide by your loan amount
Next, you take the end result from Step 2 (the total cost of your fees and interest) and divide by the amount of your loan.
Step 4: Divide by your term
The fourth step is to take the final number from Step 3 and divide by the total number of days in your loan’s term.
Be sure to divide by the number of days, and not months or years. So, if your loan is 1 year, you’ll divide Step 3 by 365; if your loan is 2 years, you’ll divide by 730, and so on.
Step 5: Multiply by 365
Next, take the result of Step 4 and multiply this number by 365. This will give you the annual rate.
Step 6: Multiply by 100%
The last step is to multiply the final product of Step 5 by 100. This will convert your annual rate into a percentage.
Keep in mind that this basic calculation does not account for compounding interest or other factors. If you have questions about your APR, contact your lender.
Understand what you owe
APR is a financial metric that describes the cost to borrow money on a specific loan from a particular lender. While APR may vary between lenders and types of loans, the basic principles remain the same.
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