What is APR and How Does it Work?

APR is one of the most common metrics in the financial world (and a recurring guest on fast-talking commercials). Understanding this metric is crucial for your financial health. It can be the difference between paying or saving a ton of money in interest when you apply for a credit card, mortgage, or loan. Let’s answer the question “ What is APR?” and review everything you need to know.

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What is annual percentage rate (APR)?

Annual percentage rate (APR) is the yearly interest rate plus any fees you pay when you borrow money. APRs provide a bottom-line number that you can use to compare products from different lenders, credit cards, or investment products. 

As a general rule, with comparable loan terms, the lower the APR the less money you’ll pay over the course of a loan.

While APR is important, you should also consider factors like the type of interest you’re being charged, fees, and the length of the loan. 

How does the annual percentage rate (APR) work? APR explained

APRs are expressed as an interest rate that’s a percentage of the total amount of money that you borrowed. Think of it like the “full price tag” of borrowing money. 

Several factors can influence the APR you pay for financial products like loans or credit cards:

1. Lender
2. Type of loan 
3. Your creditworthiness
4. Benchmark rates
5. Fees and other charges

Why is APR important?

Understanding your APR is important because it lets you know how much a loan, credit card, or other lending product will cost you in interest. Without a good understanding of APRs, you could accidentally pay hundreds (or even thousands) of dollars in interest unnecessarily. 

What are the different types of APRs?

Different lenders offer varying types of APRs depending on the financial product. Here are a few of the most common APRs that you’ll come across:

👉 Fixed APR: Your interest rate stays the same over the life of a loan. This can help you enjoy predictability in payments. Some credit cards have fixed APRs, though it’s not common.

👉 Variable APR: Your interest fluctuates based on an underlying benchmark interest rate, such as the federal funds rate. If the benchmark rate rises then your interest rate—and your costs—will likely increase as well. But, if the benchmark rate drops then your rate could decrease.

👉 Purchase APR: Your interest rate is only applied to purchases made with a credit card if you carry a balance beyond the grace period. This is the standard APR for credit cards used for most everyday transactions.

👉 Promotional or introductory APR: A temporary lower interest rate (sometimes 0%) offered for a specific period when you open a new credit card or take advantage of a special offer. Once the promo period ends, the APR reverts to the standard rate.

👉 Cash advance APR: The interest rate you’ll be charged when you withdraw cash from your credit card which is typically higher than the purchase APR. Cash advances also often accrue interest immediately, without a grace period.

👉 Balance transfer APR: The interest rate applied when you transfer debt from one credit card to another. Balance transfer cards typically offer a lower introductory rate for a limited time, which can help you save money on interest in the short term.

👉 Penalty APR: A higher interest rate that’s triggered when you violate your credit card’s terms—such as making a late payment or missing a payment entirely. This rate can be significantly higher than your standard APR and may last indefinitely.

APR vs. APY 

While annual percentage rate (APR) tells you the interest you pay on a credit card or other loan plus any fees, annual percentage yield (APY) tells you the amount of interest you’ll earn from a certain investment product, including compound interest. These two metrics are essentially two sides of the same coin:

1. APR meaning = interest paid on money that you borrow
2. APY meaning = interest earned on money that you invest or save

APR Example

Let’s say that you take out a one-year personal loan of $2,500 that has an APR of 5%. If you constantly pay down your balance with equal monthly payments then you’ll repay your loan in 12 monthly payments of $214.02 and you’ll pay $68.22 in total interest.

APY Example

Let’s say that you put $2,500 into a high-yield savings account that pays 5% APY for one year. This account compounds monthly and you’ll earn $125 in interest by the end of the year assuming that you don’t add or withdraw any more money.

APR vs. interest rate vs. daily periodic rate

These three metrics are all similar ways to calculate the amount of money that you’ll pay in interest when borrowing money. 

Annual percentage rate

• What it is: The total cost of borrowing money over a year, including the interest rate plus certain fees (if applicable).
• Where it applies: Loans, credit cards, and mortgages.
• Why it matters: It gives a more accurate picture of the total cost of borrowing than just the interest rate alone.

Interest rate

• What it is: The percentage charged only on the principal amount of a loan or credit card balance.
• Where it applies: Loans and credit cards.
• Why it matters: It affects how much interest accrues, but it doesn’t include fees like APR does.

Daily periodic rate

• What it is: The APR divided by 365 days (or 360, depending on the lender). It determines how much interest accrues each day on your balance.
• Where it applies: Credit cards and variable-rate loans.
• Why it matters: The higher your DPR, the faster interest accumulates, especially if you carry a balance.

APR vs interest rate: The APR and interest rate are similar. But, APRs include the interest rate plus any and all fees, giving you a more clear picture of your total cost.

How to calculate APR

Most lenders will advertise the APR they’re offering for a certain product. If not, then here’s how to calculate APR on a credit card or other loan:

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

For example, let’s say you borrow $5,000 with a 10% 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 $5,000 by 0.10 and then 3, giving you interest charges of $1,500
2. Multiply $5,000 by 0.05, giving you an origination fee of $250
3. Divide interest and fees of $1,750 by $5,000, giving you 0.35
4. Divide 0.35 by 1095 (the number of days in your loan term), for a result of 0.00031963
5. Multiply 0.00031963 by 365, giving you an APR of 0.116666667
6. Multiply that by 100 to convert the APR to a percentage of 11.67%

Conversely, you can also use an online personal loan calculator to help understand the interest you’re paying.

What is a good APR rate?

Instead of searching for the lowest APR, it’s better to examine all factors of a loan together like the type of interest, total fees, and loan length. 

APRs can sometimes be misleading by themselves. However, you can use the following benchmarks to understand the standard rates for different types of financial products:

1. 20 to 30%: Credit cards
2. 10 to 20%: Personal loans
3. 10 to 15%: Auto loans
4. <8%: Mortgages

Many credit cards will offer introductory rates of 0% which can help you avoid paying interest while you pay down debt. However, be wary that your rate will increase once the introductory period ends.

What Is APR? Now You Know!

Thank you so much for reading! We hope that you’ve found this article valuable in understanding what an APR is. With this information, you’ll be well-equipped to secure an attractive rate on your next credit card, personal loan, or mortgage.

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