First Things First: What is Annual Percentage Rate APR?
Annual percentage rate or APR, in its simplest form, is a number that represents the total cost of borrowing money. It’s what a lender charges you over the life of the loan to borrow money from them, the “price” they charge for extending credit. A higher APR translates to a more expensive loan, and vice-versa.
When you’re applying for a loan, a credit card, or really any type of financial product, lots of jargon-like financial terms are thrown at you. One of the most misunderstood terms is the Annual Percentage Rate (or APR). But it’s also one of the most important things to understand when considering your options for business credit.
The best way to understand this is through a simple example. Let’s say that you take out an equipment loan of $1000 with a 20% APR to buy a new pizza oven. If your bank applied interest charges once per year and you don’t pay off your balance, you will be subject to an extra $200 on top of your balance. So, the total cost of borrowing that $1000 is $200.
We’ve put together a list of the top 7 things that you need to know about APRs that you understand how annual percentage rate works and how to make informed decisions about getting business credit.
1. APR vs. Interest Rate
It’s easy to confuse APR for the interest rate on a loan or credit card, but they’re not always the same. The APR and interest rates are usually the same for credit cards because credit card APRs don’t include other fees, but this is not the case for the typical loan.
The interest rate on a loan, or any form of credit, is simply the percentage of the principal that a lender charges you to borrow money.
The APR, however, includes the interest rate and any other loan fees. For example, a bank may charge an origination fee to pay for setting up the loan. Auto dealers often charge a small fee for auto loans underwritten and handled by the dealership for taking care of the financing.
When reported, the APR on a loan will take into account all of this in the form of a percentage rate.
2. How APR Is Determined and Calculated for Loans
APR is determined by adding up all of the associated costs of borrowing and then annualizing them as an annual percentage rate.
Let’s use an example to illustrate this. Let’s say you take out a $1000 loan. Your annual interest rate is 10%, and the lender charges a $100 origination fee. To keep things simple, you’ve agreed to pay back the loan in one year.
The APR calculation is as follows:
- Step 1: Add up all interest payments and other fees. In this case, this will sum to $200.<.li>
- Step 2: Divide that number by the total loan amount, in this case, it would be $200/$1000 = 0.20.
- Step 3: Divide that number by the total number of days in the loan term. In this case, it would be 0.20 / 365 days = 0.0005479.
- Step 4: Multiply that result by 365, and then by 100 to express it as a percent. In this case, this would equal 20%!
3. How APR Works for Credit Cards
Annual percentage rate can seem pretty complicated for credit cards, both in how they work and how they’re reported. Credit card issuers will report many different APRs, with each one applying differently depending on the type of balance and your credit behavior. Below is a list of the most common credit card APRs and their implications:
- Purchase APR: This is the interest rate charged on any outstanding balance on your card that is applied each month. If you pay off your credit card balance in full by your due date, or during the card’s grace period, this APR is irrelevant.
- Introductory APR: Credit card issuers often use very low introductory APRs to attract new customers. Introductory APRs are lower APRs that apply to new purchases made by a consumer for a limited period of time after you open the card. They can be as low as 0%! This is a type of promotional APR, something you may hear about when researching credit cards.
- Penalty APR: Sometimes credit cards come with the condition that the credit card issuer can raise your APR to the highest APR allowed by your agreement. This usually happens because you’ve had multiple late payments or have been running balances consistently above your limit. These can get really expensive to deal with. They’re often as high as 30%!
- Balance Transfer APR: This is the APR applied to balances that you transfer from one card to another. Sometimes companies will offer very low balance transfer APRs to attract new customers who are looking for ways to manage their debt. Lower than normal balance transfer percent APRs are another type of promotional APR.
There are others, but these are the most common and the most relevant to most consumers.
Lucky for you, credit card companies are mandated by law to provide clear and easily accessible information to cardholders regarding the different types of APRs associated with a credit card and how they are triggered.
4. Fixed vs. Variable APR
While there are many different types of APR, the most important to understand is the difference between a fixed and variable APR.
A fixed APR is exactly what it sounds like. Fixed APRs don’t change for any reason throughout the life of the loan. The implication of this is that it’s very simple to budget the total cost of a loan because the cost of borrowing year over year remains constant.
Variable APRs are quite different. Remember, lenders are trying to make money. To do this, a lender charges interest rates. But they have to make sure that they don’t lose money because of inflation, the changes in price levels in the economy. It can get quite complicated, but basically lenders only make money if they charge interest rates that are higher than the average level of inflation.
The original APR set by a lender may become loss-making depending on changes in the economy and financial markets, so it’s often the case that APRs will be pegged to standard financial indices.
The most common index is the prime rate, the lowest interest rate that banks charge to their most credit-worthy customers. The prime rate is published in the Wall Street Journal and is influenced by changes to the federal funds rate charged by the Federal Reserve.
Okay, but what does this mean for you? If you have a variable APR, as the prime rate changes, so does your APR. This can be good or bad depending on how the prime rate, or other indices, change.
Variable-rate APRs are therefore a bit harder to budget because changes in the prime rate can’t be exactly predicted.
5. Federal APR Disclosure Laws
The Truth-in-Lending Act (TILA) is a federal mandate that requires lenders to provide consumers with a written disclosure, a “Truth-in-Lending Disclosure”, of the important terms of credit before issuing a loan.
According to the Consumer Finance Protection Bureau, TILA disclosures include the following:
- APR of the Loan: The cost of borrowing expressed as a yearly percentage rate.
- Finance Charge: The cost of credit expressed as a dollar amount including interest payments and other fees.
- Amount Financed: The total loan amount expressed in a dollar amount.
- Total of Payments: The total cost that you will end up paying through the life of the loan. This is the sum of the amount financed and finance charge.
In addition, TILA disclosures will include things like the total number of payments, the amount of your monthly payment, and penalties for late payments.
Lenders usually provide this information as a part of the loan contract. When you receive a loan contract, locate the TILA disclosure and review it in detail so that you have a full understanding of the loan before you sign the contract.
6. How to Factor APR into The True Cost of Credit
Let’s go back to our equipment loan example. The loan we took out was $1000, but we ended up also paying $200 in interest. So the true cost of credit was $1200.
This logic applies to all forms of credit. The amount that you borrow is only one aspect of what you end up paying when you take out a loan or other form of credit.
The true cost of credit combines the loan amount with any interest payments and other fees. To calculate this we have to understand the following:
- Is our rate fixed or variable?
- Is our interest simple or compounded?
- For how long will I be paying off this loan?
TILA disclosures do some of this work for you. They require lenders to report the “Finance Charge”, which is anything on top of the loan amount that you will pay over the life of the loan. This, plus the loan principal, is the true cost of credit.
So, when making a decision about securing a loan, it’s important to evaluate the decision not in terms of the amount that you’re borrowing, but what you’ll end up paying overall.
7. How to Get the Lowest APR Possible
In order to get the lowest rate possible, you need to minimize either the interest charged or the fees associated with the credit being extended (or both!).
Your interest rate is dependent on how risky a borrower you are perceived to be. The principal determinant of your risk is your personal and business credit score. If you have an excellent credit report you are seen as less risky by lenders, and that will result in lower interest rates. By taking steps to raise your credit score, like paying off existing debts or staying current on any outstanding loans, you’re on your way to a lower interest rate and a low APR.
The second-best way to get a lower APR is to shop around when looking for sources of credit. Lenders are not all the same and they can differ wildly in terms of the interest rates and fees that they charge. Do your homework and evaluate all of your possible options in terms of the total cost of borrowing before deciding on a lender.