What Is APR and Why It Matters Before You Borrow

APR, short for annual percentage rate, expresses borrowing costs on an annual basis. Many loan contracts disclose the APR with the interest and certain fees included. Credit card APRs, on the other hand, reflect the interest rate, and disclosures of credit card fees are usually made separately.

That difference can be substantial when rates are large, and other fees are disclosed with less prominence. Using APR to assess the costs of a loan will not reveal the principal and will not provide the monthly payment. To give the quote meaning, you have to read it along with the funds that you receive and the terms that have been laid out for repayment.

What the percentage actually measures

Interest is calculated based on the particular rate and balance of the loan. APR considers other fees (e.g., origination fees) and the date of the loan repayment. For example, if a lender charges an origination fee for a loan, the APR would reflect the origination fee in addition to the interest. As a result, the APR could be higher than the stated interest for the loan.

You can not generally take the interest rate and add a fee percentage to get the APR. The APR takes into account the timing of when money is transferred between the lender and the borrower. With the example of a loan that is repaid in a series of payments, the principal is reduced in each successive payment. The APR takes into account the reducing principal.

The difference between APR and interest rate becomes important when different up-front fees are charged on a personal loan. A lower interest rate can come with a higher APR. When the amount received and the payment schedule are the same, the APR shows the difference in the cost of the loan.

Read APR beside the dollars on a loan disclosure

For personal installment loans that fall under federal disclosure rules, the financial terms are combined. These terms include the APR, the amount financed, the finance charge, and the total of the payments. The rules of Regulation Z determine the function of each of these terms. Understanding these rules helps explain where the money goes.

Here’s an example of a $1,000 loan with a fixed 12% annual interest rate. The lender charges a 5% origination fee. As a result, the amount you receive is $950. You have one year to repay the loan. Each month, interest is charged at a rate of 1% of the remaining balance. Nothing else is charged.

One illustrative loan, several different cost figures

This is a financial example, not a loan offer. It is calculated to the penny. The example shown assumes that the last payment will be less than the others and will be made to clear the entire balance. Actual disclosures will vary based on the date and method of calculation of the sample shown. The amount financed may include money paid on your behalf, so it may not be the same as money deposited in your account.

The APR is actually much greater than 12%, with the fee being only $50. To begin with, you receive less money than the original principal amount of the loan. Also, you have to return the money in monthly installments. So, both of these features of the loan need to be considered while calculating the APR.

The fee is already included in the $116.19 finance charge. Adding another $50 would count it twice. The dollar cost of credit here is $1,066.19 repaid minus $950 received.

A 21.86% APR does not mean that you will pay $218.60 in interest on this loan. Your balance changes during the year. The table’s finance charge shows the scheduled cost in dollars; the APR expresses that cost as a rate.

Why a short loan can have a high annual rate

Viewing a charge as annual means looking at the charge from the perspective of a one-year borrowing charge. Annualizing does not signify that you have agreed to a one-year borrowing charge.

If a loan of $200 must be repaid in 14 days with $214, then the lending cost is $14, and the cost is 7% of the amount borrowed. Estimating this cost on an annual basis is:

($14 ÷ $200) × (365 ÷ 14) × 100 = 182.5%

The scheduled dollar charge is still $14 if you repay on time under these assumptions. The high annual rate shows the price of using $200 for only two weeks. Both figures matter: the rate describes the price relative to time, while $214 is the amount that must be available on the due date.

This shortcut only works for the sample with a single payment. This is not a formula to calculate the APR for a multi-payment loan. For a true case, use the payment and APR provided by the lender.

What a loan’s APR leaves unanswered

APR does not include all fees. There are charges that don’t count toward APR. For instance, finance charges don’t include fees that are charged for a late payment that is truly unexpected. An application fee that is charged to all applicants, regardless of whether they are approved, is not included in APR either. Other costs outside the APR can still be real costs.

An extended repayment period may change the result. With longer periods to repay the debt, loans with lower APRs may actually cost more. To determine if a loan is worthwhile, one must consider the total amount of payments and the date those payments are due.

The sample loan above shows a monthly payment of $88.85. The 21.86% APR is separate from the monthly payment. If the monthly payment impacts other essential payments, like rent, or impacts the ability to buy food, comparing APRs of different lenders does not help. Cheap loan offers do not mean that an offer should be taken.

A basic loan payment calculator may not factor APR into its calculation of a loan payment. In the example, it is assumed that the lender charges 12% interest. Entering 21.86% would account for the fee by increasing the interest rate and would overstate the payment. To accurately model a loan offer, a calculator needs the right inputs and fee treatment to match an offer.

A credit card’s APR needs a different reading

The APR a credit card applies can depend on whether you make a purchase, transfer a balance, or take a cash advance. When determining the cost of using a card, the quoted rates do not include the annual and transaction fees. The relevant APR is the one charged for the type of transaction you are planning to make.

An example of a 0% balance transfer offer with a 3% transfer fee charges a $30 transfer fee on a $1,000 balance transfer. A 0% offer doesn’t actually charge any interest during the promotional period. The transfer fee is still charged.

Many banks and financial institutions calculate interest using daily balances. The CFPB has published a resource that illustrates the effect that payment timing can have on the interest a consumer is charged on a credit card. In general, the earlier a consumer pays down their balance, the lower the interest charge will be. This is true even if the APR has not changed.

A grace period can affect how much you owe. If your card offers a grace period and you meet its conditions, paying the entire statement balance on or before the payment deadline can keep your purchases free of interest. If you have a balance, a grace period may not be offered on the following statement. Generally, interest on cash advances begins to accrue on the transaction date.

You also need to consider fees for a personal line of credit. There is more to the cost of the credit than the quoted interest rate. There can be fees for account maintenance and fees for withdrawing money. Borrowing a small amount can mean the fee is a high cost of the credit.

Zero interest and deferred interest are different offers

If the conditions are met, a 0% introductory APR credit card offer will not charge interest during the promotional period. After that period, the regular APR will be charged on the balance.

A credit card offer with “no interest if paid in full” may actually defer interest. If the full payment is not made on or before the payment deadline, interest may be charged from the date of the original purchase. The CFPB provides an example of zero percent interest vs. deferred interest promotions to clarify the difference.

With either offer, the required minimum payment may not clear the promotional balance before the deadline. The end date and the amount needed to repay the balance matter as much as the advertised rate.

Which rate applies after the offer begins?

The agreed interest rate in the $1,000 example is 12%. With a fixed-rate agreement, the interest rate charged does not change. The market rate may increase or decrease; however, the interest rate charged stays the same. An interest rate agreement with a variable rate is tied to an index, e.g., the prime rate. The terms of the agreement define the circumstances and frequency under which the rate may change.

A variable rate offer means the rate you see today could change tomorrow. Each credit card offer provides details on how rates are determined and the conditions that trigger changes. So-called “fixed” rates also mean rates could change. The terms of the contract and the applicable laws will control the situations in which a credit card issuer may change the rate.

Decreasing the lifetime of a loan can decrease the total interest paid, even if the stated APR doesn’t change. Interest savings depend on the loan terms and how the interest is calculated. Borrowing a smaller amount can also reduce the dollars paid without changing the rate. A lower bill and a lower APR are different outcomes.

When you return to an offer, you will find the APR defines one aspect of its cost. The amount provided, the nature of the charges, and the repayment schedule define the cost when money is provided and repaid.