There are two main types of costs associated with most financing products: the interest rate and the charges and fees associated with each specific loan or credit card.
- APR is a convenient calculation that combines the cost of interest and fees before expressing them as a percentage of the total loan amount or credit card balance.
- Knowing the APR on a loan will help you to compare the true cost of borrowing. That’s because it includes fees - and these tend to vary widely between lenders.
You don’t need to know the APR formula in order to use this number to compare loans. However, if you’re a numbers person or have an interest in finance here’s how the figure is calculated.
- APR = ((Fees and Interest/Principal/n)x 365) x 100
- “n” refers to the number of days in your loan term. The interest would be the total amount of interest paid over the life of the loan while the principal refers to your original loan amount.
The Types Of APR
One of the confusing things about APR is that lenders use multiple versions of it - sometimes even for the same product.
For example, your credit card provider may charge a different APR for cash advances, balance transfers, and regular purchases.
- Many credit cards charge an introductory APR of 0% for the first 12 to 18 months. When the initial period is over, your rate may jump suddenly.
- Some lenders increase your APR as a penalty measure for late payments. There’s often a clause in your loan or credit card agreement that stipulates this – that’s why it’s so good to read the fine print before you sign up for any financial product.
- Some loans have a fixed APR while others may fluctuate with changes in the federal interest rate.
- In general you’re more likely to enjoy a competitive APR if you have a credit score of 700 and above.
An Example Of APR
To illustrate how APR works, let’s take a look at the breakdown of costs on a personal loan. Keeping an eye on the interest rate, fees, and APR for each of the lending products you’re considering will help you to narrow your choices down to the most affordable options.
- A personal loan of $10,000 may come with an interest rate of 9.5% – but once fees are included in the effective APR rises to 14.0%.
- Moving down your list of loans you may notice another one which has a higher interest rate (11.0%) but a more competitive fee structure which translates to an APR of 12.5%. Although the interest rate is higher, the second loan will cost you less in total.
The Advantages Of APR
Knowing how much a loan will really cost can be invaluable when comparing the approximate cost of different products.
APR has several benefits for anyone shopping around for a loan or credit card.
- The ability to compare different products. You'll be able to run down your list of alternatives and select the provider whose total cost is lower.
- Hidden fees are easier to spot. Lenders are required by law to disclose the total cost of borrowing - and an APR is one of the most convenient ways to measure this.
The Disadvantages Of APR
No financial measure is perfect and before you use APR to determine which loan to select, you’ll want to be aware of the weaknesses of this calculation.
- There are times when it’s not that accurate. The shorter your loan term and more variable your interest rate, the less likely it is that your loan APR will reflect the true cost of borrowing.
- Lenders can choose to exclude some costs from their APRs. Once you narrow down your options, it’s a good idea to check the lender’s website or call them to verify exactly what costs are involved with the loan.
Annual percentage rate is a useful financial metric that allows you to compare the cost of different lending products while taking both interest and fees into account.
Although APR doesn’t perfectly estimate the total costs of the loan, in every case it’s still an extremely useful tool for anybody choosing the next loan or credit card.
You can also contact prospective lenders directly and ask them for a full schedule of fees to clear up any ambiguity.