What is APR?
An annual percentage rate, or APR, is often associated with credit cards and loans. But for many people, what this rate really means is somewhat mysterious. They wonder how to calculate APR interest, how it differs from an interest rate, what types of APR are available and even how to lower APR on credit card balances they carry.
If you understand the difference between interest rate and APR—as well as how each amount is calculated—you'll be in a stronger position to choose the right credit card, mortgage or loan for your situation.
How is APR defined?
According to the Consumer Financial Protection Bureau, APR is the actual price you pay when you borrow money. While both APR and interest rates define how much you're paying for a credit card or loan, the total amounts might end up being quite different.
What's the difference between interest rate and APR?
An interest rate is the amount a lender will charge you as a percentage of the amount loaned, while an APR is the total cost of borrowing money. APR includes both the interest rate you pay over the course of a year and any fees associated with the credit card or loan. Your APR will typically be higher than the interest rate because of this, but it'll also provide a clearer picture of how much it'll actually cost you to borrow.
APR charges are more complex than interest rate charges. With APR, if you don't pay your balance in full each month, credit card issuers will typically charge an APR on your daily balance. This increases throughout the month as you make additional purchases, and it decreases when you make a payment. The APR would also be applied to prior interest and fees added to your account, not just the amounts you charge to buy items.
How does APR work?
Your APR influences how much it costs you to borrow money and the amount of money you'll ultimately pay in interest over the life of a credit card balance or loan. That's why it's important to understand the factors that determine your APR so you can take steps to improve it.
A few key factors determine how to calculate APR interest. These include:
- Prime rate: Financial institutions determine their prime rate based on the federal funds rate, which can change several times a year. Lenders determine the APR they'll charge you to borrow based on the prime rate, plus an additional percentage.
- Type of loan interest rate: Credit cards often use a variable APR, so they can change in response to changes to the federal funds rate. If a loan has a fixed APR, a change to the bank's prime rate won't impact its APR.
- Loan term: In the case of a short-term loan that lasts several months or a few years, the lender will recoup its money relatively quickly as long as you repay the loan as agreed. It may be harder for the lender to recoup a loan that may span several decades.
- Loan size: A lender takes on more risk that you could default on a larger loan, so the APR for the larger loan may be higher than the one offered on a smaller loan.
- Credit history and score: Your credit history tells lenders how you've managed financial accounts like credit cards and loans. It looks at whether you pay your bills on time, your debt compared to your available credit, how long you've been using and managing credit, and what types of loans and credit accounts you have. These factors play a role in your credit score range.
- Amount of risk associated with lending: Financial institutions may base APR on other aspects of your financial life beyond credit, such as the amount of money you have in savings, brokerage or retirement accounts, as well as the value of any property you own. They also may look at your employment status and monthly income compared to your monthly debt payments.
Use APR to compare credit card offers
When you're comparing credit card offers, it's important to understand how APR affects the amount you pay to reduce a balance. If you plan to pay off your balance each month, APR may not be a large factor in choosing a card. But if you anticipate that you may sometimes pay less than your full balance, a lower APR can reduce the amount you owe in interest and fees.
You may also want to consider how you intend to use the card. Credit card APRs may vary based on type of transaction, such as a balance transfer or cash withdrawal versus a retail purchase. You may also be offered an introductory APR that will reset to a higher amount a few months later.
How can you get a lower APR?
It's important to note that credit cards often charge variable rates, so your APR can go up and down as its underlying tax rate—like the prime rate—changes.
When applying for a credit card, mortgage or other type of loan, ask about the lowest rate available. If you're not offered this rate, you can take steps to improve your overall financial picture and strengthen your credit score before applying for a new account.
- Pay down credit card balances and one or more loans to reduce monthly debt.
- Stop using credit cards for new purchases, and close inactive cards.
- Focus on saving money to make a larger down payment on a loan—and possibly get a lower rate.
- Consider a shorter loan term.
If you build a strong credit history and implement solid financial habits over time, you may be able to gradually improve the APR you're offered on personal loans and credit cards. This can ultimately lower the total amount of money it costs you to borrow.
