Another Day, Another Dollar

What is the Annual Percentage Rate?

Definition of an APR

Annual Percentage Rate (APR) is a way to evaluate the full amount of interest and fees you will pay on a loan in a given year.

  • It represents the annual cost of borrowing money including all fees and interest.
  • It’s a simple way to compare loan options.

Annual Percentage Rate is commonly used to evaluate the total cost of a mortgage; It’s also used to reflect the annual interest rate for a credit card.

Unlike the interest rate, the APR factors the effects of compounding.  As a result, it’s typically higher than the stated annual interest rate.

Podcast: Interest

Back to Basics—Interest

Interest is the amount of money paid to the lender for the privilege of borrowing money.

There are two types of interest:

Simple Interest: Interest computed only on the principal amount

Compound Interest: Interest computed on the principal amount plus interest incurred in the previous period(s)

Because you do not know in advance if you will allow interest to accrue, lenders that use compound interest can only provide an estimate of a loan’s Annual Percentage Rate. If you skip payments or pay too little, however, the amount that you actually pay on a loan, called your “effective APR,” may end up being higher than the quoted rate due to the power of compounding.

Important Terms

  • Nominal Annual Percentage Rate—This is typically what people are referring to when they say “APR.” Banks and credit card companies display this figure alongside product offers to indicate the projected annual cost of borrowing money. To determine your projected monthly interest rate, simply divide the nominal Annual Percentage Rate by 12. This is also called your “monthly periodic rate.”
  • Accrued Interest—This is the amount of previously unpaid interest charges. This amount is added to the balance of the loan and earns additional interest.
  • Effective APR—The annual amount you actually pay, expressed as a percentage of the loan amount, including compounding, fees, and other charges. This is the most comprehensive measure of the cost of a loan. Effective APR can’t be perfectly predicted because it depends on your payments, degree choice, accrued interest, and any late fees.

Calculator: Who wants to be a millionaire?

APR and Credit Cards

The average credit card APR in 2015 was 15% or more. Credit cards often charge interest daily rather than monthly. To determine your “daily periodic rate,” simply divide the APR by 360 or 365, depending on the card issuer.

However, if you play your cards right (pun intended), you may not actually end up paying any interest at all. If you have a credit card, even one with a high APR, you can avoid paying even $1 of interest by simply paying your full balance every month. As long as you don’t let a balance sit on your card and always pay on time, you will not incur any interest charges.

Fun Facts:

  • If you fail to make on-time payments, the Annual Percentage Rate on your credit card can jump to 29.99%.
  • The current average mortgage Annual Percentage Rate is below 3.5%; However, it climbed as high as 16% in 1982.

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