Annual Percentage Rate (APR): What It Means and How It Works

What Is Annual Percentage Rate (APR)?

Annual percentage rate (APR) refers vĩ đại the yearly interest generated by a sum that's charged vĩ đại borrowers or paid vĩ đại 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 tài khoản. The APR provides consumers with a bottom-line number they can compare among lenders, credit cards, or investment products.

How the Annual Percentage Rate (APR) Works

An annual percentage rate is expressed as an interest rate. It calculates what percentage of the principal you’ll pay each year by taking things such as monthly payments and fees into tài khoản. APR is also the annual rate of interest paid on investments without accounting for the compounding of interest within that year.

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The Truth in Lending Act (TILA) of 1968 mandates that lenders disclose the APR they charge vĩ đại borrowers. Credit thẻ companies are allowed vĩ đại advertise interest rates on a monthly basis, but they must clearly report the APR vĩ đại customers before they sign an agreement.

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 vĩ đại the balance.

$\begin{aligned} &\text{APR} = \left ( \left ( \frac{ \frac{ \text{Fees} + \text{Interest} }{ \text {Principal} } }{ n } \right ) \times 365 \right ) \times 100 \\ &\textbf{where:} \\ &\text{Interest} = \text{Total interest paid over life of the loan} \\ &\text{Principal} = \text{Loan amount} \\ &n = \text{Number of days in loan term} \\ \end{aligned}$​APR=((nPrincipalFees+Interest​​)×365)×100where:Interest=Total interest paid over life of the loanPrincipal=Loan amountn=Number of days in loan term​

Types of APRs

Credit thẻ APRs vary based on the type of charge. The credit thẻ issuer may charge one APR for purchases, another for cash advances, and yet another for balance transfers from another thẻ. Issuers also charge high-rate penalty APRs vĩ đại customers for late payments or violating other terms of the cardholder agreement. There’s also the introductory APR—a low or 0% rate—with which many credit thẻ companies try vĩ đại entice new customers vĩ đại sign up for a thẻ.

Bank loans generally come with either fixed or variable APRs. A fixed APR loan has an interest rate that is guaranteed not vĩ đại change during the life of the loan or credit facility. A variable APR loan has an interest rate that may change at any time.

The APR borrowers are charged also depends on their credit. The rates offered vĩ đại those with excellent credit are significantly lower kêu ca those offered vĩ đại those with bad credit.

APR vs. Annual Percentage Yield (APY)

Though an APR only accounts for simple interest, the annual percentage yield (APY) takes compound interest into tài khoản. As a result, a loan’s APY is higher kêu ca its APR. The higher the interest rate—and vĩ đại a lesser extent, the smaller the compounding periods—the greater the difference between the APR and APY.

Imagine that a loan’s APR is 12%, and the loan compounds once a month. If an individual borrows $10,000, their interest for one month is 1% of the balance, or $100. That effectively increases the balance vĩ đại $10,100. The following month, 1% interest is assessed on this amount, and the interest payment is $101, slightly higher kêu ca it was the previous month. If you carry that balance for the year, your effective interest rate becomes 12.68%. APY includes these small shifts in interest expenses due vĩ đại compounding, while APR does not.

Here's another way vĩ đại look at it. Say you compare an investment that pays 5% per year with one that pays 5% monthly. For the first month, the APY equals 5%, the same as the APR. But for the second, the APY is 5.12%, reflecting the monthly compounding.

Given that an APR and a different APY can represent the same interest rate on a loan or financial product, lenders often emphasize the more flattering number, which is why the Truth in Savings Act of 1991 mandated both APR and APY disclosure in ads, contracts, and agreements. A ngân hàng will advertise a savings account’s APY in a large phông and its corresponding APR in a smaller one, given that the former features a superficially larger number. The opposite happens when the ngân hàng acts as the lender and tries vĩ đại convince its borrowers that it’s charging a low rate. A great resource for comparing both APR and APY rates on a mortgage is a mortgage calculator.

APR vs. APY Example

Let's say that XYZ Corp. offers a credit thẻ that levies interest of 0.06273% daily. Multiply that by 365, and that’s 22.9% per year, which is the advertised APR. Now, if you were vĩ đại charge a different $1,000 item vĩ đại your thẻ every day and waited until the day after the due date (when the issuer started levying interest) vĩ đại start making payments, you’d owe $1,000.6273 for each thing you bought.

To calculate the APY or effective annual interest rate—the more typical term for credit cards—add one (that represents the principal) and take that number vĩ đại the power of the number of compounding periods in a year; subtract one from the result vĩ đại get the percentage:

$\begin{aligned} &\text{APY} = (1 + \text{Periodic Rate} ) ^ n - 1 \\ &\textbf{where:} \\ &n = \text{Number of compounding periods per year} \\ \end{aligned}$​APY=(1+Periodic Rate)n−1where:n=Number of compounding periods per year​

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In this case your APY or EAR would be 25.7%:

$\begin{aligned} &( ( 1 + .0006273 ) ^ {365} ) - 1 = .257 \\ \end{aligned}$​((1+.0006273)365)−1=.257​

If you only carry a balance on your credit thẻ for one month’s period, you will be charged the equivalent yearly rate of 22.9%. However, if you carry that balance for the year, your effective interest rate becomes 25.7% as a result of compounding each day.

APR vs. Nominal Interest Rate vs. Daily Periodic Rate

An APR tends vĩ đại be higher kêu ca a loan’s nominal interest rate. That’s because the nominal interest rate doesn’t tài khoản for any other expense accrued by the borrower. The nominal rate may be lower on your mortgage if you don’t tài khoản for closing costs, insurance, and origination fees. If you kết thúc up rolling these into your mortgage, your mortgage balance increases, as does your APR.

The daily periodic rate, on the other hand, is the interest charged on a loan’s balance on a daily basis—the APR divided by 365. Lenders and credit thẻ providers are allowed vĩ đại represent APR on a monthly basis, though, as long as the full 12-month APR is listed somewhere before the agreement is signed.

Disadvantages of Annual Percentage Rate (APR)

The APR isn’t always an accurate reflection of the total cost of borrowing. In fact, it may understate the actual cost of a loan. That’s because the calculations assume long-term repayment schedules. The costs and fees are spread too thin with APR calculations for loans that are repaid faster or have shorter repayment periods. For instance, the average annual impact of mortgage closing costs is much smaller when those costs are assumed vĩ đại have been spread over 30 years instead of seven vĩ đại 10 years.

APR also runs into some trouble with adjustable-rate mortgages (ARMs). Estimates always assume a constant rate of interest, and even though APR takes rate caps into consideration, the final number is still based on fixed rates. Because the interest rate on an ARM will change when the fixed-rate period is over, APR estimates can severely understate the actual borrowing costs if mortgage rates rise in the future.

Mortgage APRs may or may not include other charges, such as appraisals, titles, credit reports, applications, life insurance, attorneys and notaries, and document preparation. There are other fees that are deliberately excluded, including late fees and other one-time fees.

All this may make it difficult vĩ đại compare similar products because the fees included or excluded differ from institution vĩ đại institution. In order vĩ đại accurately compare multiple offers, a potential borrower must determine which of these fees are included and, vĩ đại be thorough, calculate APR using the nominal interest rate and other cost information.

The Bottom Line

The APR is the basic theoretical cost or benefit of money loaned or borrowed. By calculating only the simple interest without periodic compounding, the APR gives borrowers and lenders a snapshot of how much interest they are earning or paying within a certain period of time. If someone is borrowing money, such as by using a credit thẻ or applying for a mortgage, the APR can be misleading because it only presents the base number of what they are paying without taking time into the equation. Conversely, if someone is looking at the APR on a savings tài khoản, it doesn't illustrate the full impact of interest earned over time.

APRs are often a selling point for different financial instruments, such as mortgages or credit cards. When choosing a tool with an APR, be careful vĩ đại also take into tài khoản the APY because it will prove a more accurate number for what you will pay or earn over time. Though the formula for your APR may stay the same, different financial institutions will include different fees in the principal balance. Be aware of what is included in your APR when signing any agreement.