It seems that just about everything you purchase these days has mentions of APR, yet there’s not a lot of talk about what these 3 letters stand for, nor how they work. So I’m going to attempt to break it down to the best of my ability. Feel free to add any comments, tips or any other advice below in the comments section.
What Does APR Mean?
What is APR and what does it mean? APR stands for Annual Percentage Rate, which, in layman’s terms, is a percentage measurement of the amount of interest that the principal amount will cost you each year (annualized). When you borrow money you will almost always have to pay back interest on that borrowed money, even if it’s a friend or family member. This interest is paid back with the principal of the loan, which is how creditors and lenders make their money. This is how they are able to take risk(s) in lending money to consumers and businesses, whether it’s a Credit Card, Business loan, personal loan, mortgage or auto loan.
But there are different types of Annual Percentage Rates that you will come across, so let’s take a look at these.
A fixed APR means that the creditor has agreed, by contract, to keep your interest at a fixed number until the debt is paid. This is what you should always look for if given the option(s).
OK, now that you understand that part, what about Variable APR? This one is a little bit tricky, as this means that the company can actually change the interest rate as they please, to whatever rate they please, within the law, when they feel they need to. If you’re late on a payment they can increase your interest rate to a much higher interest rate. Be careful when dealing with Variable APR.
There’s also Tiered APR but we won’t get into that here as it depends on what tier the debt falls into.
How APR Works
Let’s take a look at an example of APR and how it can affect you, the consumer, when choosing the best offers available to you. Please see the next section on how APR affects Credit Cards as there is a difference, and you can even get around having to pay APR.
Say you wanted to get a loan for $200,000 (USD) and the lender stated that there would be a (fixed) 7.5% Interest Rate on this loan. We’ll keep this example super simple and make the months set at 12 (one year payoff schedule) with no points or any other costs. So right now we have:
Loan Amount: $200,000
Interest Rate Percentage: 7.5%
The monthly payment will come out to be $17,351.48
The total payment will equate to: $208,217.80
The Total Interest is: $8,217.80
How do you calculate this APR? It’s pretty simple, actually. First, with this loan, we want to break it down into months. So we simply say:
7.5% / 12 = 0.625 (Monthly APR)
Note: if you wanted to check Daily APR you would change the 12 for 365.
Now we have to remember that we are breaking this loan down into 12 months, so the first month would be equal to: $1,250.00 in interest.
But here’s where it starts to get tricky due to payments. After you pay off the first payment your balance decreases, which means that the principal and interest payment goes down as well. So it would look like the following:
Month Start Balance Principal Interest Payment
|1||$ 200,000.00||$ 16,101.48||$ 1,250.00||$ 17,351.48|
|2||$ 183,898.52||$ 16,202.12||$ 1,149.37||$ 17,351.48|
|3||$ 167,696.40||$ 16,303.38||$ 1,048.10||$ 17,351.48|
|4||$ 151,393.02||$ 16,405.28||$ 946.21||$ 17,351.48|
|5||$ 134,987.74||$ 16,507.81||$ 843.67||$ 17,351.48|
|6||$ 118,479.93||$ 16,610.98||$ 740.50||$ 17,351.48|
|7||$ 101,868.95||$ 16,714.80||$ 636.68||$ 17,351.48|
|8||$ 85,154.14||$ 16,819.27||$ 532.21||$ 17,351.48|
|9||$ 68,334.87||$ 16,924.39||$ 427.09||$ 17,351.48|
|10||$ 51,410.48||$ 17,030.17||$ 321.32||$ 17,351.48|
|11||$ 34,380.32||$ 17,136.61||$ 214.88||$ 17,351.48|
|12||$ 17,243.71||$ 17,243.71||$ 107.77||$ 17,351.48|
Hopefully this makes sense, as the 12 payments may cause confusion to some.
How APR Works for Credit Cards
Credit Cards are actually different when dealing with APR as you don’t have to pay the interest rates on most cards (that I know of) as long as the balance is paid off in full each month. So if you have a credit card with a limit of $1,500 and you had a balance of $1,403.32 on that card, you would have to pay off the balance in full before the next monthly payment was due in order to not have to pay interest on the balance.
So basically you do not have to pay any interest on the cards if you keep them paid off before each monthly payment is due. This is a great way to not only save money by not paying those fees, but also keeping your credit score up and building your credit history.
As we mentioned before, APR usually works in terms of months for most loans, but with credit cards it’s quite different. If you have a balance on your card at the end of each billing cycle you will be charged interest rate based on days, not months. This is important to remember as it adds up quite quickly for some people. This is known as ADB, or Average Daily Balance.
Calculating your ADB requires a bit more math, so we won’t dig into it here. However, with ADB and APR you should keep in mind that the charges increase each day, which means that with each passing day that you don’t pay on your bill – you’re going to pay more and more charges. It works similar to the above graph with paying down a loan, except it goes the opposite way! This is due to the fact that your credit card is considered revolving debt, that continuously goes up and down as payments and charges are made over the months.
This means that you should always do your best to pay off your balance(s) each and every month, or else you’ll pay more in fees due to the ADB and APR adding up quickly.
Please note: this doesn’t mean that you won’t have other fees associated with your card(s), so please look over the fine print to ensure that you’re not going to have a surprise charge(s) on those cards.
How Does APR Work for Mortgages?
Mortgage APR is different from the interest rate, as the interest rate represents the cost of borrowing money, whereas mortgage APR represents the yearly cost of money borrowed on a yearly basis (“annually”), which can include any lender fees and even costs associated with the loan, such as closing costs, origination fees, mortgage insurance and interest. The APR applies to the interest rate of the promissory note, not the monthly payment of the mortgage.
It’s important to understand that APR is just an estimate and it can change if there are any changes with the amount of the loan, the term of the loan, etc. There are various ways that this can change so be sure to read any fine print and ask any questions relative to these fees.
When shopping for loans you need to compare not just APR, but also the interest rates associated with the loans you’re being marketed with. Always pay close attention to ensure you’re not looking at one and thinking about the other.