Annual percentage rate, or APR, is a commonly used term associated with loans and credit cards. While many people are familiar with the term APR, many also do not understand exactly how it works. And understanding APR is crucial for you to make educated decisions when it comes to your finances.
What Is APR?
The APR is the amount of interest that a lender will charge you yearly for borrowing money. APR takes fees that you may incur into account, generally making it higher than a regular interest rate.
How Does APR Work?
When it comes to APR and credit cards, there is some good news. The first one is that you don’t necessarily have to pay for the APR. Your credit card has a grace period, and if you pay your full balance within that period, there will be no interested applied. However, if you decide to leave some credit behind and carry it over, the bank will then add the APR rate to your outstanding balance.
The second thing to note is that charges such as annual or late fees won’t affect your credit card APR. When it comes to other loans such as mortgages, additional charges such as closing costs will be taken into account for your APR, raising the amount of interest you pay.
How APR Is Calculated
To calculate an APR rate, follow these steps:
- Add all of the fees and interest that you will have to pay during the loan duration.
- Take that amount and divide it by the amount of the loan.
- Now, take that number and divide it by the number of days in the loan term.
- Now, multiply the resulting number by 365.
- And finally, multiply by 100 to get the percentage rate.
Fixed APR vs. Variable APR
Not all APR is the same. If you’re dealing with a variable APR, the rate will fluctuate based on an index (most likely the U.S Prime Rate, published by the Wall Street Journal). On the other hand, if you have a fixed APR, it doesn’t follow any index. Changes that occur within a fixed APR will be based on missed payments or changes in the market and must be announced by the lender up to 45 days before they take effect.
One thing to note is that credit cards are based on a variable APR. And in that case, the bank calculates what you owe as follows:
- They first calculate the APR by adding the U.S Prime Rate and to any margins that they might charge.
- Then, they divide that rate by 365 to get a daily rate.
- They multiply the days in the billing period by this daily rate and multiply the result by the outstanding balance.
- The resulting number is the interest that they will be adding to your balance.
Types of APR
For credit cards, the APR you pay will vary widely depending on the type of card that you use.
Purchase APR: This is the most common one. The APR rate will be applied based on credit card purchases.
Cash Advance APR: If you plan on borrowing money from your credit card by asking for checks and cash advances, you can expect a higher APR. There are no grace periods involved in this case.
Penalty APR: This is one of the highest APRs, and it comes into play when the rules are broken. This can mean things like violating conditions or failing to make payments on time.
Introductory APR: Banks may lure customers by offering special APR rates that are much lower than the standard ones. These offers will only apply for a certain amount of time, and once the time is up, the APR rate will increase.