WTFinance is APR and how does it work?

Not too long ago, I was comparing different loan options. One of the factors I looked at was the interest rate. After all, aren’t we supposed to compare interest rates when we review loan choices?

I realized, though, that many lenders refer to the APR. I notice this detail tossed around a lot, but what does it mean? You might have some of the same questions I had, so let’s take a look at APR and how it works.

What is APR?

APR stands for annual percentage rate. It’s a way to let you know the total cost of borrowing money for a whole year. You’re likely to come across the term APR when you get credit cards, loans, and mortgages.

The APR isn't the same as the interest rate. The APR includes the interest rate and all the fees. 

If there are no fees, then the APR and interest rate will be the same. If there are fees, then the APR will be higher than the interest rate.

How is APR calculated?

As with all things money, APR is about math. The lender uses a formula to first add up the loan’s interest and fees and spread them over the life of your loan, and then come up with the figure for how much your loan costs you in one year. 

Since APR is affected by both the interest rate and the fees, it can be a good way to compare loans. Some loans advertise very low interest rates but charge very high fees. Others have higher rates but low or no fees. Checking out the APR on the loans you’re considering can help you compare the actual cost of each loan.

Two types of APR

There are two main types of APR. 

• Credit card APR: On a credit card, the APR is the same as the interest rate. Credit cards have fees (like late fees or balance transfer fees) but not everyone pays them. If there’s an annual fee, that’s the fee for owning the card, not for carrying any debt. So the formula to calculate APR on a credit card is simple: APR = interest rate. 

• Installment loan APR: On an installment loan, the APR includes the interest rate and the loan fees. A personal loan is an example of an installment loan. When you get a personal loan, there might be origination fees and other charges. These fees are usually wrapped into your loan, meaning your APR is probably going to be a bit higher than your interest rate. When you get a loan, the lender is required to tell you what fees you’ll have to pay, and the APR for the loan. 

Factors that impact your interest rate

Since the interest rate is the most important factor influencing the cost of your loan, it’s a good idea to understand the factors that affect it. 

When reviewing your application and assigning your interest rate, a credit card issuer, mortgage lender, or personal loan lender will look at:

• Your credit standing: Your lender will want to know about your experience with credit. Your credit report, which lists all of your past loans, and your credit score are both used as part of your credit history. Lenders usually have at least three or four interest rates to offer, based on what your credit score is. 

• Your income: Your income, compared to your debts, tells the lender how much of a loan you can afford. Some lenders charge different interest rates for smaller loans compared to large loans.

• Loan type: Secured loans (like home equity loans) tend to have lower interest rates than comparable unsecured loans (like personal loans). If a loan is secured, you’ve pledged something of value as a guarantee that you’ll repay the loan. For a home equity loan, the home is the collateral. For a personal loan, there is usually no collateral.

• Lender discounts: Some lenders offer discounts that permanently lower the interest rate on your loan. If you can score a discount, that will lower your APR.