Annual percentage rate (APR) explained

What’s the true cost of borrowing money? To answer that question, we’ll need to explain APR (or Annual Percentage Rate).

APR represents the total cost of borrowing money over the course of a year. A common misconception is that APR only reflects your interest rate. In fact, APR also reflects additional fees that may be associated with opening credit or taking out a loan.

In this guide we’ll explore the differences between APR for credit cards and APR for loans. We’ll also take a look at how to minimize your APR costs to ensure you’re not paying more than you must.

Continue reading to learn how to make wise decisions when opening credit or taking out loans.

APR is the total cost of borrowing money over the course of 365 days, expressed in the form of a percentage. It paints a more realistic and accurate picture of how much a credit card or loan will really cost.

APR tends to be more accurate than looking at interest rates alone. That’s because APR factors in the additional costs and fees associated with borrowing. As a result, it reflects the true cost of opening a line of credit.

Sometimes, APR is reflected as a single fixed rate, known as fixed APR. However, different transactions may have different rates. That tends to be the case with credit cards.

The different types of APRs include:

• Fixed APR. Stays the same throughout the loan term or credit card agreement. 

• Variable APR. Fluctuates based on an index rate, so your interest rate could increase or decrease over time. 

• Nominal APR. The basic interest rate before considering compounding or additional fees. 

• Effective APR. Includes the effects of compounding interest. 

• Simple APR. Calculated only on the principal loan amount. 

• Compound APR. Accounts for accumulated interest. That means interest is charged on both the original balance and any previously accrued interest. 

APR is calculated slightly differently for loans and credit cards. We’ll explain the differences between them below.

Here’s a basic breakdown of how APR differs for credit cards and for loans.

• APR for credit cards. APR is essentially the interest rate that applies to your balance when you don’t pay it off in full each month. Credit card APR does not always include extra fees in the calculation.
• APR for loans. The APR includes not only the interest rate plus other costs. For example, loan origination fees, closing costs, or mortgage insurance.

Now, we’ll explain how interest and APR are related.

The interest rate is the base cost of borrowing money. Interest rates are typically expressed as a percentage. They represent the amount a lender charges you just for using their money.

APR includes the interest rate plus any additional costs associated with the loan or credit. This makes APR a more accurate reflection of the total cost of borrowing. As a general rule, the higher the APR, the more interest you’ll owe if you don’t pay off the balance.

For example, imagine taking out a loan with a 5% interest rate. You might assume the cost of borrowing is 5%. However, that loan also involves fees. As a result, your APR might be 6% or higher.

With credit cards, APR is essentially the same as the interest rate. However, APR only applies to balances you don’t pay off in full.

Most credit cards use compound interest. That means Interest is charged on both the principal and previously accrued interest. As a result, the actual amount you pay is often much higher than what the APR suggests.

We’ll explain more about credit card APR below.

Credit card APR is applied daily, not annually. That means credit card companies calculate and add interest to your balance every day. Unless your balance is paid off in full, APR will apply each day you carry a balance of any amount. However, the total interest typically isn’t reflected in your balance until the end of your billing cycle.

The amount of interest added each day is known as your daily periodic rate. To calculate this rate, divide your APR percentage by 365. For example, if your credit card APR is 18%, your daily interest rate would be 18% ÷ 365 = 0.0493% per day. Credit card interest compounds over time.

Credit card APR can vary based on several factors, including your creditworthiness and the type of transaction. Here are the most common types of credit card APR explained:

• Purchase APR. The standard APR is applied to everyday purchases made with the card. If you pay off your full balance by the due date each month, you won’t be charged interest. However, the purchase APR will apply to the remaining amount if you carry a balance. 

• Balance Transfer APR. When you transfer a balance from one credit card to another, the balance transfer APR is applied. 

• Cash Advance APR. If you use your credit card to withdraw cash from an ATM or bank, you’ll be charged a much higher APR. Interest begins accruing immediately, with no grace period. Penalty APR. If you miss a payment, your credit card issuer may apply a penalty APR.  This penalty is typically significantly higher than your regular APR. This rate may apply indefinitely unless you make a series of on-time payments.

Here are a few tips that could help with minimizing APR costs:

• Pay your full credit card balance each month. 

• Choose low or 0% APR credit cards. 

• Pay more than the minimum balance whenever possible. 

• Improve your credit score to qualify for lower APRs. 

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.