What is an annual percentage rate (APR)?

The annual percentage rate (APR) is a number that represents the total yearly cost of borrowing money, expressed as a percentage of the principal loan amount. 

Regular bank loans, overdrafts, credit cards and mortgages all have annual percentage rates. This means lenders can, in theory, shop around and get the best and cheapest rate for the loan they want. 

Highlights

How the annual percentage rate works

If you want to understand APR, then you will need to know that it is, at its core, an interest rate. The idea is that the APR shows a borrower, or potential borrower, the percentage of the loan they will pay back as interest over the course of 12 months, taking into account factors like fees and monthly payments. 

There is a difference between APR and the annual equivalent rate (AER). AER is the amount of interest to be paid and does not include any fees. Traditionally, AER included compound interest and APR did not. However, nowadays effective APR is often calculated and does take compound interest into account. 

Technically speaking, effective APR is the same as annual percentage yield (APY), which is APR plus compound interest. It could be argued that APR is less useful than other metrics when it comes to judging the cost of long-term lending where rates can change, such as mortgages.

Why is APR important?

APR is important because it can give a borrower an idea of how much they will have to pay on top of repaying their loan over the course of a year. In many jurisdictions, lenders have a legal requirement to show what the APR of any product they have. 

Knowing the APR can theoretically allow a borrower to know how much a loan is going to cost, in the long run. They can then make a more informed decision about whether or not they can afford to pay back the loan. 

How is APR calculated?

If someone wanted to work out their APR they would have to do the following annual percentage rate calculation.

Firstly, they should find the interest rate and charges. Then, they should add that to the loan’s fees.

Then they should divide the number they have by the current balance of the loan. That number should be divided by the amount of days in the loan’s term. 

Then, multiply that by 365 to get the annual rate as a figure, and then multiply that by 100 to get it as a percentage. 

Below is the APR formula:

For example, suppose you’re considering a loan of $1,000 with a 10% annual interest rate and a $50 one-time origination fee. The loan term is 90 days.

Calculate the daily interest rate: 0.10 (annual interest rate) / 365 (days in a year) = 0.00027397.

Calculate the total interest for 90 days: $1,000 * 0.00027397 (daily interest rate) * 90 (days) = $24.96.

Add the origination fee: $24.96 (interest) + $50 (fee) = $74.96.

Divide the total cost by the loan amount: $74.96 / $1,000 = 0.07496

To annualize the cost, divide 365 days by the loan term (90 days) and multiply by the previous result: (365 / 90) * 0.07496 = 0.30662.

Multiply by 100 to get the percentage: 0.30662 * 100 = 30.66%

The APR for this 90-day loan is approximately 30.66%.

There are different types of APR. With credit cards, APR can change based on whether the card is used for purchases, withdrawing money or transferring a balance. Credit card holders are often charged a higher APR if they make late repayments or if they break the terms of their agreement in any way.

Credit card companies might also have a promotional APR for people at the start of their credit card deal, often offering an annual percentage rate of 0% to try to persuade people to sign up.

A more traditional  lender, such as a bank, might issue a loan with fixed APR, which means that the annual percentage rate stays the same throughout the course of the loan, or it could issue one with a variable APR. 

Factors that affect APR

There are a number of different things that have an impact on APR.

• Credit score and credit history. Customers with a strong credit history and a good credit score can usually get a more favourable APR than those without them.

• Income and debt-to-income ratio. Individuals with a higher income who do not already have a lot of debt can usually get a better APR than people on a lower income with a lot of debt. 

• Loan term and amount. The longer a loan is for, the higher its APR is likely to be. Similarly, larger loans often carry a higher APR.

• Type of loan. Generally, credit card loans have a higher APR than personal loans, which have higher APRs than car loans, which have a higher APR than mortgages. 

Conclusion

The annual percentage rate is the amount of interest that a person who takes out a loan can expect to pay back over the course of a year, expressed as a percentage. APRs can vary from person to person and product to product. In many places lenders have to show their product’s APR by law, so it might be worth a borrower shopping around to get the best deal. 

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