February 27, 2019

What is APR?

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Not sure what APR means? You're not alone. But APR, or Annual Percentage Rate, is important when it comes to credit cards or loans. Read on to learn more about APR and how it can lead to debt.

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APR Basics

APR is the percentage rate of interest you are charged on a loan. It's a cumulative number, meaning it includes the rate of

  • Interest
  • Fees
  • Administrative/Brokerage Costs
  • Other Expenses

You'll often hear the term APR in reference to credit cards, mortgages, and auto loans.

With a mortgage and auto loan, the APR is used to calculate the interest you pay each month on the principal loan amount.

With a credit card, your APR is the rate charged on any purchases you don't pay by the balance due date.

What's the difference between APR and Interest Rate?

  • Interest Rate: DOES NOT include any fees charged for the cost of the loan.
  • APR: INCLUDES interest rate, fees, and other costs.

This means you should always compare the APR, not interest rate when loan shopping.

Simple vs Compound Interest

Simple Interest
Every monthly interest payment reduces the principal balance. Any interest charged does not get added to the overall outstanding balance.

Most mortgage and car payment loans use simple interest.

Compound Interest
Any interest charged on the previous debt amount gets added to your total loan amount. In other words, you could end up paying interest on previously owed interest.

Credit cards and student loans use compound interest.

TIP: Pay off your credit card every month. Unlike with mortgages and auto loans, interest is completely avoidable with credit cards. If you don't carry a balance, you won't be charged.

What Is Variable APR?

There are two types of APRs: fixed and variable.

Fixed
The rate stays the same the life of the loan. With variable APR, the rate is calculated off a moving financial benchmark. In the US, lenders tend to use the US prime rate and add a fixed number of basis points.

If you open a credit card that has a variable APR of 14%, then your total APR would be the US prime rate plus 14%. If the prime rate is 4%, your total interest rate is 18%.

Your rate can change on a monthly, quarterly, or yearly basis, depending on your loan terms.

The US prime rate signifies the lowest rate a bank will charge for interest. It is the rate preferred customers receive for short to medium term loan products.

Variable APR Credit Cards
Most credit cards use a variable rate APR rather than fixed. When interest rates are low, this can seem like a great bargain.

But variable APR is tricky. If interest rates were to rise, so will your interest rate. Historically, interest rates don't jump a major amount overnight.

TIP: Keep a close eye on the baseline benchmark your lender uses when taking on variable rate debt. If rates start to rise, you should aim to pay off the debt faster. Otherwise, you'll pay higher interest expenses.

Fixed Rate vs Adjustable Rate Mortgages
Mortgage lenders will often provide you with the option to take on either a fixed rate or what they call an adjustable rate mortgage.

Think of adjustable rates as variable APRs. Lenders use a financial benchmark like the US prime rate or a certain US treasury bond and then add on a fixed number of basis points. Each month, you'll pay a different amount of interest on your principal loan amount.

When interest rates are low, adjustable rate mortgages are great. But if you like consistency with your bills, you will probably prefer a fixed rate mortgage. That way, you'll owe the same amount towards your mortgage each month.

Variable APR Terms to Know

Make sure you understand the following terms when researching variable APR loans:

Prime rate: Benchmark rate used by lender. Will fluctuate daily.

Margin: Fixed percentage that, when added to the prime rate, calculates your total APR.

Interest rate caps: This limits the amount your APR can increase over a certain period, protecting you and your wallet from major rate increases.

Types of APR Credit Cards

Credit cards usually come with several different APR rates, depending on how you use the card. Read on to learn about how your APR will change depending on your credit use.

Purchase APR
The purchase APR refers to the standard APR you pay on an outstanding credit card balance. If you pay off your credit card in full every month, you won't pay a purchase APR.

Introductory/Promotional APR
Lenders use introductory or promotional APRs to entice people to open new credit cards and build a balance.

Often, a card will offer a 0% APR for a set period, meaning you'll pay no interest on your balance month to month. Once the period expires, the regular purchase APR will kick in and your outstanding balance will start to accrue interest.

Lenders often use introductory and promotional interchangeably. Sometimes promotional APR will offer a lower or 0% APR only for certain types of purchases, like airline tickets.

Balance Transfer APR
Balance transfer credit cards offer lower APR rates for balances transferred from another card.

A balance transfer APR can help you pay off credit card debt faster by decreasing or eliminating your interest expense for a set period.

Cash Advance APR
If you borrow cash from your credit card, you'll owe interest based on the card's cash advance rate.

A card's cash advance APR is usually higher than the purchase APR. Most lenders also charge cash advance fees in addition to the higher rate.

Penalty APR
If you consistently pay late, miss payments, or charge over your credit limit, your credit card company may calculate your interest from the penalty APR in your credit card agreement. It is the maximum APR allowed in your agreement.

Pull-Out Box: Average APRs for Different Credit Cards
According to U.S. News, the average credit card APR is between 16.60% and 23.46%

Type of Card Avg. Min. APR Avg. Max APR
Travel Rewards16.76%23.97%
Airline17.35%24.75%
Hotels17.74%24.88%
Business15.6%22.95%
Cashback15.58%23.77%
Student16.55%24.87%

How to Calculate Your APR

Credit Card
Your credit card statement lists the APR used to calculate your interest charges - if any - at the top of the statement.

This is also where you'll see the length of your billing cycle, your total outstanding balance, and the minimum payment amount due that month.

Since credit card APRs are variable, be sure to check each month what rate you are being charged.

APR = Daily Interest Rate × Average Daily Balance × Billing Cycle

Let's say you have a credit card with an outstanding balance of $1,000 and an APR of 20% that compounds daily. The billing cycle is 30 days.

  • Daily Interest Rate = 20% ÷ 365 = 0.055%

Next, find your average daily balance. Start with the outstanding balance and divide by the number of days on the billing cycle.

  • Average Daily Balance = $1,000 ÷ 30 = $33.33

Now multiply your average outstanding balance by the daily interest rate and billing cycle length to calculate the APR that's added daily.

  • APR = 0.055% × $33.33 × 30 = $0.55

The first day your balance is overdue, your new outstanding balance becomes $1,000.55.

Remember, every payment you miss, your outstanding balance will grow a little larger, and you'll be charged interest on it.

WARNING: By making only the minimum payment on your credit card - usually $25.00 - you'll reduce your outstanding balance by that amount but be charged interest on the rest. This can quickly add up to serious debt.

Each credit card calculates compound interest a little differently, depending on the number of days in a billing cycle and whether it compounds daily or monthly.

  • Card Compounds Daily: You are better off making payments more frequently to reduce your average daily balance.

  • Mortgage and Auto Loans: Mortgage and auto loans include the interest rate plus any additional closing costs or fees associated with the loan.

    Since mortgage loans have durations of 15 to 30 years, the calculation is more complex than credit card APR and best done with an Excel spreadsheet.

To demonstrate how to calculate an APR with closing costs, we'll use an example.

Let's say you take out a 30-year fixed rate $100,000 mortgage with a 5% annual interest rate and $2,000 in closing costs.

Step 1: Calculate Monthly Payment

Use the spreadsheet function PMT(rate,nper,pv,fv,type)

  • Rate: 0.05÷12, which is your 5% interest rate divided by 12 months
  • Nper: Number of payment periods, which in this case is the number of monthly payments in 30 years, or 30×12 = 360
  • PV: Present value of the loan, so $100,000

In the spreadsheet, enter =PMT(0.05,360,100000). You can ignore the FV and type inputs. Your monthly payment is $536.82. (When you calculate it, the spreadsheet will return it as a negative number.)

Step 2: Calculate APR

Use the spreadsheet formula =RATE(nper,pmt,pv,fv,type,guess). You can ignore FV, type, and guess.

  • Nper: Use your 360 months again
  • Pmt: Use the $536.82 calculated in the previous step. Keep it as a negative number.
  • Pv: Present value of the loan minus any fees, which in this case would be $100,000 - $2,000 = $80,000

Enter =RATE(360,-536.82,80000) to get your monthly rate.

Multiply by 12 to calculate an APR of 5.18%.

This method works for both auto loans and mortgage loans.

How to Get a Low Credit Card APR

Open a 0% Introductory APR Card
If opening a new credit card, look for issuers offering introductory 0% APR. You won't pay interest on any purchases while the 0% APR period lasts.

Remember, the 0% APR will only last for a limited time. For any balance you carry after the promotional period ends, you'll be charged interest.

You Should Know: To qualify, you'll need to meet certain credit score requirements. Your credit score is based on:

  • Payment history: Your track record of making credit card payments on time.

  • Credit utilization ratio: The ratio of your charged expenses to your credit limit. Aim to keep this under 30%.

  • Length of credit history: The longer you've had certain credit accounts open, the better your score.

  • New credit inquiries: The number of applications you make for new credit lines. Limit the number of applications made at one time, as each application makes minor damage to your credit score.

  • Importance of making payments on time: Avoid late payments.

Balance Transfers
Balance transfers can decrease your interest expense on an outstanding card balance. Research balance transfer credit cards that offer an introductory reduced or 0% APR.

You will likely have to pay a balance transfer fee on the transferred balance. Most credit cards charge a balance transfer fee around 3% of the transferred balance.

You could also opt to transfer a balance to a current credit card.

WARNING: Most credit cards charge a separate APR for transferred balances. This means you could end up paying more with the new APR and balance transfer fee.

Ask Your Credit Card Issuer
You may be granted a lower APR by calling your credit card issuer. Tell the customer representative how long you've been a customer.

Be sure to mention any positive financial changes since you opened the card, like a salary raise or decrease in debt, that show you are a quality customer.

Have a specific number in mind you'd like for your revised APR. If you can find a competing credit card offering the lower rate you'd like, bring this up to the representative and see if the issuer will match it.

Shop Around
Different credit card issuers and card types offer different APRs. Before opening a new card, comparison shop between different issuers to find the best APR for you.

How to Get a Low Mortgage APR

Provide a Large Down Payment
The larger your home down payment, the better rate you'll get. If you can provide 20% or greater of the home's purchase price, you'll secure a favorable rate.

If you can't afford a 20% down payment, many lenders will accept a down payment as low as 5% but require private mortgage insurance, which adds to your total cost.

Private mortgage insurance protects lenders if you default on your loan. With a lower down payment, you'll likely have a higher interest rate too.

Improve Your Credit Score
Before you start the home buying process, check your credit score. Lenders will be more likely to offer you a good rate if you have a high credit score.

Most lenders have minimum credit score requirements of 620 to 640. If you can raise your credit score to above 700, you're in great shape for securing a favorable APR.

Take Out a Shorter Loan
Shorter mortgage loans have lower APRs and higher monthly payments. You'll save on interest expense but be prepared for the higher monthly cost.

When shopping for a mortgage, decide how much you can afford to pay each month towards your mortgage. If you have room in the budget, you can opt for a shorter mortgage and pay more per month with a lower APR.

Comparison Shop
Compare the mortgage rates you're offered by credit unions, banks, and online lenders to understand the best rate you could get.

If you're working with a real estate agent, ask if they can provide a referral to a certain lender in your area.

TIP: Limit your shopping and application period to a two-week period. If you go beyond the two weeks, the multiple credit inquiries may lower your credit score.

Applications made within two weeks are viewed by credit agencies as one application.

Use Home Buying Programs
Several government programs provide options for first-time homebuyers that might offer a lower APR. See the list below for programs you may qualify for:

  • VA Loan: If you or your spouse are active military or veterans, you could be eligible for a VA housing loan. The loan requires no down payment and does not require private mortgage insurance.

    The loan's interest rates are competitive with other mortgage rates. Although the program boasts having no qualifying minimum credit score, be aware the participating lenders do have minimums.

  • FHA Loan: FHA loans benefit young first-time homebuyers with a shorter credit history. They require as low as a 3.5% down payment and are open to most US residents.

  • Good Neighbor Next Door: If you work as a law enforcer, firefighter, EMT, or teacher, you could be eligible for this program.

    It provides up to a 50% discount on the list price of homes in revitalized areas - as long as you commit to living in the home for at least 36 months.

  • USDA Loans: The USDA homebuyers assistance program is meant for first-time homebuyers living in rural areas. For eligible participants, no down payment is required.

How to Get a Low Auto Loan APR

Comparison Shop Financing Deals
When shopping for an auto loan, check with financial institutions rather than the dealership. Private lenders, like credit unions and online banks, usually offer better terms and lower rates than a dealership.

If you secure a loan prequalification, you can go to the dealer with a blank check that is usable up to a certain amount. You can potentially use this to negotiate better financing with the car dealer after the car's purchase price has been agreed to.

Work on Your Credit
A good credit score will always improve your chances at securing low financing rates. Just like mortgage lenders, auto loan lenders will provide better rates for scores above 700.

In addition to keeping your credit score healthy, limit your loan application period to two weeks. When you make multiple applications within a two-week period, credit agencies count them all as one request. Making multiple credit requests in a short period of time can damage your credit score.

You Should Know: Many car dealerships will advertise "0% APR and $0 down" as a promotional campaign. What they don't advertise is that people must have a high credit score to be approved for the 0% APR.

Don't Get Caught Up in Monthly Payment Figures: Most of us like to look at expenses on a monthly basis. But if you focus too much on the monthly cost of your auto loan rather than the overall cost, you'll end up with a higher rate and large cost.

A shorter loan with a lower APR but large monthly payment will cost you less overall than a longer loan with a smaller monthly payment.

Car dealerships will sometimes offer customers the choice of low financing or a cash rebate. You can decide which is the better deal by using an online calculator.

The Bottom Line

APR helps you compare different loan rates because it includes all extra fees and costs associated with the loan.

With your credit card, pay your balance in full every month to avoid accumulating compound interest. With a mortgage or auto loan, shop around within a two-week period with credit unions and banks to find the best rate.

The best way to secure a low APR is to keep your credit score high. Whatever you do, make sure to research your options and read the terms of your interest rate carefully before taking on any debt.

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