What’s APR and Why Does it Matter?
By John Boitnott
APR, or Annual Percentage Rate, is often featured on credit card ads and marketing collateral for vehicles, mortgages and loans along with a number. But how much do you know about what, exactly, APR is?
For many, it can be a mysterious concept. Here are some of the questions to consider:
- Why are there different types of APR, such as an introductory APR?
- Why is APR used by lenders, and how is it determined?
- How should the APR affect your decisions when shopping for a credit card or loan?
- What's the difference between APR and APY?
- Did you know your credit score could help determine this annual rate?
Our guide walks you through everything you need to know about Annual Percentage Rate (APR). Having this information can help you make a more informed decision about applying for a loan or credit card
Defining Annual Percentage Rate
The APR represents the interest on the money you borrow on an annualized basis. Whether you’re taking out a personal loan, mortgage loan, private student loan
, car loan or other loan, or you’re applying for a credit card, the APR determines the cost of the money you borrow.
APR vs. APY
Although APR and APY sound similar, there is a difference between these interest rate calculations. APY stands for Annual Percent Yield and represents what you can earn
in interest. You’ll find APY on savings accounts, certificates of deposit, money market accounts
, and similar deposit accounts. There will not be an APY on a loan or credit card.
In contrast, APR is about what you pay
in interest. It is most frequently discussed in relation to consumer credit cards, automobile financing, mortgages and loans.
How does APR work?
APR kicks in when you carry a balance on a loan or credit card. While you will pay interest on most loan products, you can avoid APR interest if you use credit cards wisely
If you pay off your statement balance on a monthly basis, then credit card APR won’t matter. That’s because there will never be any need to calculate or pay interest. Once you carry a balance on your credit card, however, the APR kicks in.
The APR starts out as a U.S. Prime Rate
, which is an index used to set variable interest rates. The bank connected to that loan or credit card adds a margin to the U.S. Prime Rate. The APR is the total of these two numbers.
Banks use a formula that includes daily or monthly periodic interest. The formula determines how much interest you must pay on an outstanding balance. Some accounts have more than one APR, each with their own rate and calculation.
Types of APR
You’ll need to pay attention to the various types of APR you might encounter across various types of financial products. Here are some examples of APR types that you could receive on one credit card account:
- A Purchase APR is a rate applied to any purchases you make using that credit card.
- A Cash Advance APR is for any cash you borrow against that credit card. Even within one credit card account, there may be cash advance checks offered with one APR. A different APR may apply to other cash advance opportunities.
- An Introductory (or Promotional) APR refers to a low APR that the credit card company applies for a limited time. The intro APR is for certain transactions, cash advances and balance transfers. Sometimes, this APR type is also referred to as a Balance Transfer APR.
Not every credit card will have all these types of APR, but the Penalty (or Default) APR applies to all credit accounts
, although it varies by amount. It tends to be the highest APR you’ll see. That's because it's meant as a deterrent or punishment for late payments
or credit limit overages. This APR may also apply to any other violation of the credit card’s terms and conditions.
You should also understand other categories of APR:
- Nominal APR: The interest rate stated on a loan
- Effective APR: Takes into consideration other fees on your loan or credit card balance.
- Fixed rate vs. variable rate APR: A fixed APR remains the same throughout the loan (although a credit card company can change a fixed APR if they give you 45 days notice). A variable APR can change without any previous notice.
Why APR matters
The amount of APR determines how expensive your loan or credit card purchase will be as you pay for it over time. Generally, the worse your credit is, the higher your APR could be – meaning the more money you could owe over time.
There is a difference in application and calculation to consider before taking out a loan or getting a credit card.
APR and credit cards
There are many things to think about with APR when you are looking for a credit card. Consider these factors as well as your current financial position.
If you already have a credit card balance, then you might want to transfer that balance to a promotional credit card. For a limited time, these credit cards offer 0% APR on the debt you are moving. Take that interest savings and use it to make a larger monthly payment on your credit card debt
to help you quickly get rid of that balance.
Conversely, if you are going to make a big purchase and know you will carry a balance, find out which credit cards offer an introductory zero percent APR. That way, you can use the interest-free period to get it paid off more easily.
Just be careful – 0% interest rates usually don’t last forever. So if you ring up a big charge on a 0% card, but the interest changes after a few months, you could face a much bigger bill than you anticipated.
APR and loans
When it comes to shopping for a loan for a car, home or other line of credit, it’s important to know the difference between your interest rate and the APR. While many may think these are the same, they aren't.
Your interest rate
is the percentage charged on the full amount of the loan. That rate applies to the full amount of the loan.
, by contrast, is applied to the amount you finance. For example, on a mortgage or auto loan, you may also finance other loan costs. These costs can include points that reduce your interest rate, prepaid interest, private mortgage insurance (PMI) and underwriting fees for a mortgage, or tax and license fees for a vehicle.
Although the APR doesn't technically affect your monthly payment, it does show the true cost of your loan. Federal Truth in Lending
laws require that lenders disclose the APR on advertised interest rates.
If there's a huge difference between the interest rate and the APR, then that means those aforementioned loan costs are high. That’s a sign that you might want to look elsewhere for your mortgage or auto loan.
However, if the interest rate and APR are closer together — say, within a half percentage point — then it’s worth considering.
Other things to know about APR
To make the best possible decisions about selecting and managing loan products and credit cards, here are a few other things to keep in mind. ...
For example, the law determines how credit card companies should handle your minimum monthly credit card payments with many types of APRs (balance transfer, introductory, etc.). The credit card company must apply the minimum monthly payment you make to the highest APR. Anything you pay above that minimum amount due is then applied to the lower APR balances.
Also, the Credit Card Accountability, Responsibility and Disclosure Act (CARD) of 2009 requires lenders to lower your APR from the penalty rate you are paying to the normal APR rate after you have made on-time payments for at least six consecutive months.
How to avoid high APRs
Since your credit score and history impact the APR you’re offered, it is a good idea to work on improving your credit before
applying for a loan or credit card. A lower credit score could result in a higher interest rate, since lenders want to cover the risk that you might not pay back what you owe.
By building your credit
, you can prove that you are a worthy candidate for a loan or credit card with a lower APR and become a more attractive borrower to lenders.
About the author
John Boitnott is a longtime digital media consultant and journalist who covers technology trends, startups, entrepreneurship and personal finance for Inc, Entrepreneur, Business Insider, USA Today and other major publications.