Annual Percentage Rate (APR) refers to the yearly interest generated by a sum that’s charged to borrowers or paid to investors. APR is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan or income earned on an investment. This includes any fees or additional costs associated with the transaction but does not take compounding into account. The APR offers consumers a bottom-line figure they can compare among lenders, credit cards, or investment products.
Key Takeaways
- Holistic Rate: An annual percentage rate (APR) is the yearly rate charged for a loan or earned by an investment, including interest and fees.
- Transparent Disclosure: Financial institutions must disclose a financial instrument’s APR before any agreement is signed.
- Consumer Protection: The APR ensures a consistent basis for presenting annual interest rate information, protecting consumers from misleading advertising practices.
- Varying Calculations: APR may not reflect the actual cost of borrowing as lenders have flexibility in its calculation, potentially excluding certain fees.
- Simple vs. Compound Interest: APR shouldn’t be confused with APY (annual percentage yield), a calculation that includes the compounding of interest.
Understanding the Annual Percentage Rate (APR)
APR is expressed as an interest rate and calculates what percentage of the principal you’ll pay each year by taking factors such as monthly payments and fees into account. It represents the annual rate of interest paid on investments without considering the compounding of interest within that year.
The Truth in Lending Act (TILA) of 1968 mandates that lenders disclose the APR they charge to borrowers. While credit card companies can advertise interest rates on a monthly basis, they must clearly report the APR to customers before they sign an agreement. Moreover, companies can increase interest rates on new purchases but not on existing balances if they provide a 45-day notice.
How Is APR Calculated?
APR is calculated by multiplying the periodic interest rate by the number of periods in a year in which it was applied. It does not indicate how many times the rate is actually applied to the balance.
APR = \\[ (n \times \frac{\text{Fees} + \text{Interest}}{\text{Principal}}) \div 365 \]\times 100\\where:\\Interest = \text{Total interest paid over life of the loan}\\Principal = \text{Loan amount}\
= \text{Number of days in loan term}
Types of APRs
Credit card APRs vary based on the type of charge. The issuer may charge different APRs for purchases, cash advances, and balance transfers from another card. High-rate penalty APRs might also be applied for late payments or other term violations. There’s also the introductory APR, a low or 0% rate many credit card companies use to attract new customers.
Bank loans generally come with either fixed or variable APRs. A fixed APR guarantees that the interest rate will not change during the life of the loan. A variable APR may change at any time. The APR borrowers are charged also depends on their credit. Those with excellent credit often receive much lower rates than those with poor credit.
Compound Interest or Simple Interest?
APR does not take into account the compounding of interest within a specific year: It is based only on simple interest.
APR vs. Annual Percentage Yield (APY)
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Though an APR only accounts for simple interest, the annual percentage yield (APY) takes compound interest into account. As a result, a loan’s APY is higher than its APR. The higher the interest rate—and to a lesser extent, the smaller the compounding periods—the greater the difference between the APR and APY.
For example, if a loan’s APR is 12% compounded monthly, then borrowing $10,000 will accrue $100 in interest the first month, adjusting the balance to $10,100. Interest for the next month will then apply to the new balance, creating a slight increase monthly, culminating in an effective interest rate of 12.68% after a year. APY captures these shifts in interest due to compounding, while APR doesn’t.
APR vs. APY Example
Consider that XYZ Corp. offers a credit card with daily interest of 0.06273%. Multiplied by 365, this results in an advertised APR of 22.9%. Charging $1,000 daily and waiting until post-due date to make payments results in a cost of $1,000.6273 each day.
To calculate APY:
APY = (1 + \text{Periodic Rate})^n - 1\\where:\
= \text{Number of compounding periods per year}
So your APY or EAR would be 25.7%:
((1 + 0.0006273)^{365}) - 1 = 0.257
APR vs. Nominal Interest Rate vs. Daily Periodic Rate
An APR tends to be higher than a loan’s nominal interest rate because the latter doesn’t account for additional expenses accrued by the borrower. Conversely, the daily periodic rate is the APR divided by 365, representing daily charges.
Lenders and credit card providers may represent APR monthly as long as the full 12-month APR is listed before signing the agreement.
Disadvantages of Annual Percentage Rate (APR)
Who Calculates APR?
APR calculations might understate actual costs, especially with long-term repayment schedules. Lenders autonomously determine how to calculate APR, including or excluding various fees. Variable-rate loans present additional complications, as future rate hikes aren’t reflected in initial APR estimates. Therefore, it may not include other charges like appraisals, credit reports, and attorney fees.
Consumers must compare multiple offers thoroughly, including careful attention to which fees are included or excluded.
Why Is the Annual Percentage Rate (APR) Disclosed?
Consumer protection laws ensure APR disclosure to prevent misleading advertisements. For instance, without APR disclosure, companies could mask high annual rate products using seemingly low monthly interest rates.
What Is a Good APR?
A “good” APR depends on factors like market rates, prime rates, and the borrower’s credit score. Competitive markets may offer low APRs to premium customers. Remember that seemingly attractive APRs may be introductory and revert to higher rates, while low rates generally favor those with high credit scores.
How Do You Calculate APR?
The formula for APR calculation is straightforward:
APR = ((n \times \frac{\text{Fees} + \text{Interest}}{\text{Principal}}) \div 365)\times 100\\where:\\Interest = \text{Total interest paid over life of the loan}\\Principal = \text{Loan amount}\
= \text{Number of days in loan term}
The Bottom Line
APR represents the basic cost or benefit of money loaned or borrowed, presenting only the simple interest number. This measure can sometimes mislead when making decisions on loans or deposits without considering time-based setups like compounding.
APRs are key financial terms for financial products like mortgages and credits. Always examine APR alongside APY for a complete picture. Different institutions might highlight varied fees, so be cautious and thorough when making your pick.
Related Terms: Interest Rate, Annual Percentage Yield (APY), Compound Interest, Simple Interest, Fixed APR, Variable APR, Nominal Interest Rate, Effective Annual Interest Rate.
References
- Federal Register. “Truth in Lending (Regulation Z)”.
- Federal Trade Commission. “Truth in Lending Act”.
- Consumer Financial Protection Bureau. “When Can my Credit Card Company Increase my Interest Rate?”
- Consumer Financial Protection Bureau. “Part 1030—Truth in Savings (Regulation DD)”.
