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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 may charge 1% a month, and its APR is 1% x 12 months, or 12%.

Loans are offered with either fixed or variable APRs. A fixed APR loan has an interest rate that is guaranteed not to change during the life of the loan or credit facility. A variable APR loan has an interest rate that may change at any time.

APR vs Interest Rate

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

For example, if you were considering a mortgage for $200,000 with a 6% interest rate, your annual interest expense would amount to $12,000, or a monthly payment of $1,000. But say your home purchase also requires closing costs, mortgage insurance and loan origination fees in the amount of $5,000. In order to determine your mortgage loan's APR, these fees are added to the original loan amount to create a new loan amount of $205,000. The 6% interest rate is then used to calculate a new annual payment of $12,300. Divide the annual payment of $12,300 by the original loan amount of $200,000 to get an APR of 6.15%.

The federal Truth in Lending Act requires that every consumer loan agreement list the APR along with the nominal interest rate. The scenario most confusing to borrowers is when two lenders are offering the same nominal rate and monthly payments but different APRs. In a case like this, the lender with the lower APR is requiring fewer upfront fees and offering the better deal.
 

APR vs Annual Percentage Yield

An APR takes only simple interest into account. In contrast, annual percentage yield (APY), also known as effective annual rate (EAR), takes compound interest into account. As a result, an APY tends to be larger than an APR on the same loan. The higher the interest rate, and to a lesser extent the smaller the compounding periods, the greater the difference between APR and APY.

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 effectively increases his balance to $10,100. The following month 1% interest is assessed on this amount, and the interest payment is $101, slightly higher than it was the previous month. If you carry that balance for the year, your effective interest rate becomes 12.68%. APY includes these small shifts in interest expenses due to compounding, while APR does not.

Or, say you compare an investment that pays 5% per year with one that pays 5% monthly. For the first, the APY equals 5%, same as the APR. But for the second, the APY IS 5.12%, reflecting the monthly compounding.

Another example: XYZ Corp. offers a credit card that levies interest of 0.06273% daily. Multiply that by 365, and that’s 22.9% per year, which is the advertised APR. Now, if you were to charge a different $1,000 item to your card every day, and waited until the day after the due date (when the issuer started levying interest) to start making payments, you’d owe $1,000.6273 for each thing you bought. To calculate the APY or EAR (the more typical term on credit cards), add 1 (which represents the principal) and take that number to the power of the number of compounding periods in a year; subtract 1 from the result to get the percentage {(1 + periodic rate)^#of periods} - 1. In this case, your APY or EAR would be 25.7% (1 + .0006273^365 = 1.257; 1.257 - 1 = .257).

If you only carry a balance on your credit card for one month's period you will be charged the equivalent yearly rate of 22.9%. However, if you carry that balance for the year, your effective interest rate becomes 25.7% as a result of compounding each day.

Given that an APR and a different APY can be used to represent the same interest rate, it stands to reason that lenders and borrowers will emphasize the more flattering number to state their case (the Truth in Savings Act of 1991 mandated that both APR and APY be disclosed in ads, contracts and agreements). A bank will advertise a savings account’s APY in a large font and its corresponding APR in a smaller one, given that the former features a superficially larger number. The opposite happens when the bank acts as lender, and tries to convince its borrowers that it’s charging a low rate.

APR vs 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. Lenders and credit card providers are allowed to represent APR on a monthly basis as long as the full 12-month APR is listed somewhere before the agreement is signed.

Is APR Misleading?

As all of the above illustrates, APR can be a misleading indicator of actual costs. Some experts feel the APR is best used to compare long-term loans. Even with shorter-term debt, such as a seven-year note, the APR actually understates the cost of the loan. This is because APR calculations assume long-term repayment schedules; for loans that are repaid faster or have shorter repayment periods, the costs and fees are spread too thin with APR calculations. The average annual impact of closing costs is much smaller when those costs are assumed to have been spread over 30 years instead of seven to 10 years.

APR also runs into some trouble with adjustable-rate mortgages, or ARMs. APR estimates always assume a constant rate of interest, and even though APR takes rate caps into consideration, the final number you are presented with is still based on fixed rates. Because the interest rate on an ARM is uncertain once the fixed-rate period is over, APR estimates can severely understate the actual borrowing costs if mortgage rates rise in the future.

 

How Do Credit Card Companies Set APR?

Most credit cards have floating APRs, commonly called variable APRs. These feature floating interest rates that move up and down along with the market or an index or the U.S. prime rate. They are set by taking this variable feature and adding the bank's margin to it. For example, if the bank charges a 10% margin and the prime rate is 5%, the borrower pays a 15% interest rate.

Though they are few and far between, there are also some fixed interest rate credit cards available. With credit cards (unlike other types of loans), a fixed APR actually means that the rate remains locked until the lender decides to change it. However, it cannot be changed without written notice, and the adjustment only applies going forward on the loan, not retroactively.

In some cases, credit card companies offer different APRs for different types of charges. For example, a card may charge one APR for purchases, another for cash advances, and third for balance transfers from another card. Similarly, banks charge high-rate penalty APRs to customers who have made late payments or violated other terms of the cardholder agreement, and offer low-rate introductory APRs to entice new customers – preferably those who tend to carry a balance on their cards.

Introductory APRs can have positive effects on personal finance if they are managed carefully. A $2,000 loan balance that carries a 12% APR incurs a $20 interest charge each month. Transferring that balance to a credit card with an introductory APR of 0% for 12 months allows you to apply that same $20 to the principal, paying off the balance much sooner.

Further Abroad

 
The definition of, and reporting requirements for, APR all pertain to American lenders. United Kingdom and European laws also emphasize disclosures with regard to APR, but lenders in those countries may calculate APR using different algorithms for different sorts of loans. Other nations have no laws or regulations at all.

 

 
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