APR, also known as annual percentage rate, is a common term used by lenders to describe the cost of borrowing on consumer loans for autos, credit cards, student loans and mortgages. Knowing what APR's are, how they're calculated, and how they impact one's personal financial bottom line can make you not only smarter financial consumer, but a better borrower, as well.
APR's became more prevalent on the personal financial landscape after Congress passed the Truth in Lending Act back in 1968. That law mandated creditors and lenders to be more transparent about the real cost of borrowing money or using a credit card, giving consumers a more encompassing and accurate idea of the cost of obtaining a credit card or getting a loan.
With loans and credit cards so pervasive on the U.S. economic landscape, there's much at stake with APR's. Just know going in that there are many layers to the APR discussion, and there are substantial differences between loan APR's and credit card APR's.
Savvy financial consumers will want to know the difference if they want to save cash on loans and credit card debt.
APR Vs. Interest Rates
For credit and loan consumers, APR comes down to one key issue: how much you're going to pay in extra interest and charges for a loan or for using a credit card on an annual basis. That said, APR's aren't exactly the same as interest rates (although they both share certain commonalities.)
APR's differ from traditional interest rates in one key way - they add fees and discounts to the interest portion of a loan or credit card payment. For example, on a mortgage loan, APR will add closing costs and other fees to the interest owed on the loan, providing a more explicit cost of borrowing to financial consumers.
Let's break down the difference between mortgage APR and credit card APR this way:
- APR is calculated by lenders and creditors as the total annual cost to the recipient, including any extra charges and fees.
- Interest rate is the annual cost of credit or a loan to a financial consumer, expressed as a percentage rate.
There's a good reason for the disparity between the two. By law, lenders and creditors must meet specific guidelines on APR's in accordance with the Federal Truth in Lending Act. In fact, any consumer loan contract must reveal the APR to the borrower.
That makes it easier for financial consumers to compare loan deals, by comparing the side-by-side APR costs on various loan and credit deals.
What APR Means For Mortgage Loans
APR is a particularly important issue for mortgage loans, since the borrower is usually paying back a huge sum of money.
Mortgage loans come with a single APR, and it includes the total principal amount of the loan, the interest rate, points on the loan, and fees and additional charges. Again, the interest rate on the loan is not the APR - it simply expresses the amount of money you'll spend each year to repay the mortgage loan. Fees or additional costs are included in the APR.
Given the fact that the APR on a mortgage loan does include those additional costs, expect the APR on your loan to be higher than your mortgage interest rate.
Weighing the fees associated with APR largely depends on the time you'll spend in the home you're financing with a mortgage loan. Typically, the longer you stay in the home, taking the lowest APR deal makes sense. But if you only plan to stay in the home for 10 years or less, it could be a good move to take a higher APR with fewer upfront fees and costs, as the entire cost of the loan will be more cost efficient over the short term.
That's because APR spreads the costs of all those extra fees and charges over the life of the mortgage loan. Thus, the shorter your stay in the home, the more money you'll save with a higher APR that comes with lower fees.
What APR Means For Credit Cards
Given that APR is the total interest rate lenders charge consumers for credit and loans, it only makes sense that credit card customers need to keep a sharp eye on annual percentage rates.
Unlike mortgage loans, credit cards often have more than one APR for consumers to weigh. Usually, that category includes the following:
- Introductory APR: This is normally a low or even no-interest rate offered by the card company to motivate consumers to apply for their credit card. Card providers set specific timetables for introductory APR's which are usually between six and 24 months. After that, expect those intro rates to rise, which adds to the total cost of your credit card.
- Balance transfer APR: When transitioning from a current credit card to a new one, your APR will include balance transfer fee expressed as a percentage of the balance being transferred to the new card (likely 3%-or-more of that balance.)
- Purchase APR: This APR is expressed as the annual percentage rate linked to the total purchases you've made with your credit card. You can avoid the purchase APR by paying your monthly card bill on time.
- Cash advance APR: APR's also apply to cash advances (the APR will be expressed as a percentage of the money taken out in a cash advance) and to late payments (this is a higher percentage rate that's applied if you're 60 days or more late in paying your credit card bill - sometimes as high as 30%.)
What mortgage loans and credit card APR do have in common is that lenders will examine your credit history first before determining your APR. The better your credit health, the lower your APR is likely to be.
How to Calculate APR on a Mortgage
The formula for figuring out a mortgage loan APR considers all the costs associated with the loan, including closing costs. To get your APR, divide the closing costs by the total term of the loan (usually 30 years.) Add that total amount to the mortgage loan interest to get your APR.
You'll need to know the following to calculate your mortgage loan APR:
- Your home's value. (example = $300,000)
- Your loan amount (example = $260,000)
- Your interest rate. (example = 4.5%)
- Your loan term. (example = 30 years)
- Discount and origination points. (example - two)
- Any additional costs. (example = $1,200)
By calculating your total home loan costs using the above figures, your total APR on a $260,000 loan is 4.75%
How to Calculate APR on a Credit Card
Calculating your credit card APR is different from figuring out your mortgage loan APR.
In this instance, you'll need to convert your APR to a daily percentage rate.
Do so by dividing your APR by 365 (the number of days in the calendar year). Every day, your credit card provider will simply multiply your current credit card balance to calculate your daily credit card interest rate. Card providers will add that rate your credit card balance the next day.
Or, calculate your credit card APR using the U.S. prime rate, plus the interest rate charged by your financial institution. In this instance, if the U.S. prime rate is 3.25% and your financial institution's card interest rate is 5%, your calculation is 3.25 plus five, which equals an 8.25% APR.
Note that credit card APR calculations depend on so-called variable interest rates that change by the day, which will impact your APR on a daily basis.
It's important to keep a close eye on your card APR, so you always know the amount of interest you're paying on your credit card.