Annual Percentage Rate - APR

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What is an 'Annual Percentage Rate - APR'

An annual percentage rate (APR) is the annual rate charged for borrowing or earned through an investment, and is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction but does not take compounding into account. As loans or credit agreements can vary in terms of interest-rate structure, transaction fees, late penalties and other factors, a standardized computation such as the APR provides borrowers with a bottom-line number they can easily compare to rates charged by other lenders.

BREAKING DOWN 'Annual Percentage Rate - APR'

By law, credit card companies and loan issuers must show customers the APR to facilitate a clear understanding of the actual rates applicable to their agreements. Credit card companies are allowed to advertise interest rates on a monthly basis but are also required to clearly state the APR to customers before any agreement is signed. For example, a credit card company may charge 1% a month, but its APR is 1% x 12 months, or 12%.

What Are the Differences Between APR and Interest Rates?

An interest rate refers to the interest charged on a loan, and it does not take any other expenses into account. In contrast, APR is the combination of fees and the interest rate. As a result, APR tends to be higher than a loan's nominal interest rate.

What Is the Difference Between APR and Annual Percentage Yield?

Unlike APR, annual percentage yield (APY) takes compound interest into account. For example, imagine the APR of a loan is 12%, and the loan compounds once per month. If an individual has borrowed $10,000, his interest for one month is 1% of his balance or $100. That increases his balance to $10,100. Without taking the borrower's payments into account, the following month 1% interest is assessed on this amount, and the interest payment is $101, slightly higher than it was the previous month. APY includes these small shifts in interest expenses due to compounding while APR does not.

How Do Credit Card Companies Set APR?

Most credit cards have floating APRs, and these are set by adding the U.S. prime rate to the bank's margin. For example, if the bank charges a 10% margin and the prime rate is 5%, the borrower pays a 15% interest rate.

In some cases, credit card companies offer different APRs for different types of charges. For example, a card may charge one APR for purchases and another for cash advances. Similarly, banks charge penalty APRs, high rates for customers who have made late payments or violated other terms of the cardholder agreement, and introductory APRs, low rates to entice new customers.

What Is the Difference Between APR and Daily Periodic Rate?

The daily periodic rate is the interest rate charged on a loan's balance on a daily basis. It is the APR divided by 365, the number of days in a year. Similarly, the monthly periodic rate is the APR divided by 12.