We’ve all seen it, the big three letter APR phrase when we check out our monthly credit card or loan statement. But how many of us truly understand what it means or how it is calculated? If you don’t, it’s a good idea to grasp the basics as it can help you make the best decisions when it comes to borrowing.
APR is short for Annual Percentage Rate and is one of the primary terms used within the loan industry to refer to interest rates.
The Cost of Doing Business
No matter what type of loan or credit you acquire, it will almost always cost you money. This is how lenders make their profits and why they issue loans in the first place. There are numerous fees and charges and ways that a loan can cost you, but the most common method by which this is calculated and presented is as an interest rate.
To understand this it is also important to understand other loan phrases. The amount you borrow is called the principal. So if you borrowed $1,000 from the bank, the principal amount is $1,000. When you pay back your loan you will be paying back both the principal and any fees and interest on top. This may be in one lump sum (as is the case for payday loans) or in regular installments (most other types of personal and business loan).
The interest you are charged is calculated as a percentage of the principal. So in very basic terms, if your loan of $100 has a fixed interest rate of 2%, then the total amount of interest you would pay is $2. That’s $2 on top of the principal and £102 altogether.
However not all loans work that way and you may have noticed both an APR and an interest rate listed. For some loans with extra fees or mortgages that have a range of other charges (broker fees, closing costs etc), these are also divided and included in the APR. This is why there is sometimes a difference, with the APR showing as higher than the interest rate.
It is also important to recognize that your APR (remember ‘Annual’ Percentage Rate) is an annual or yearly rate. In other words it’s the interest rate expressed yearly, not necessarily over the full term of the loan.
For example if you had a loan of £2,000 with an APR of 10% over three years, you would expect to have paid £20 in one year (10%), but £60 over the loan’s full three year term. Conversely if you had a payday loan of $300 for two weeks at an APR of 200%, the amount of interest you pay is only £16.67.
Over a year or annually, it would have been $600, but because the loan is only outstanding for two weeks you can take that 600, divide it by 72 weeks in a year and then multiply by the two weeks the loan is outstanding.
Credit cards are much the same. For example you may have an APR 18% and your balance for that month is $500. Thankfully you won’t have to pay $90, because that is the annual rate. That month’s interest would be $7.50, which is $90 divided by 12. In real terms you may also have to pay a portion of the principal and other fees, so the actual amount you pay would likely by higher than $7.50.
Fortunately although APR can be confusing, the Truth In Lending Act requires lenders to fully disclose all rates and fees before a borrower signs any contract. All of this information as it pertains to your own loan will be in your copy of the terms (a small booklet or pdf).
Fixed vs Variable APR
In our examples so far we have used what is known as a fixed APR, meaning the rate never changes over the course of the loan. A variable APR is therefore an interest rate that does fluctuate over the loan term. The variable rate however is not a wild number that changes on a whim or is moved by the lender in spite or to make more money. In the United States It is typically pegged to the prime lending rate (the interbank rate published each month by the Wall Street Journal). This happens to be the rate large banks charge each other for overnight borrowing.
APR is fixed to this because it’s stable but reflective or the wider financial market. For example if you were given a really low interest rate and interest rates in general went up, the lender wouldn’t be doing too well. Likewise if you were given a high interest rate and rates went down, you won’t be effected too much as your rate will come down comparatively.