An annual percentage rate is the amount of simple interest that is created from money that is borrowed by a consumer. The term comes from calculating the price of a loan over the course of a specific time frame that is usually a year. Another way that interest or APR is earned is via investments such as stocks or private lending.
How Does an APR Work?
An APR or annual percentage rate, works by taking into account the principal amount on a loan based product which is funded by an institution. This amount is divided into monthly installments that provide a net payment amount which is then attached to your yearly interest.
Because interest rates are a byproduct of credit based items such as credit cards, mortgages, or motor vehicle loans, they must remain compliant with federal standards such as the Truth in Lending Act and the Consumer Protection Act. These regulations protect consumers who may potentially enter into financial contracts that aren’t completely understood by requiring full disclosures of their lending products.
How to Calculate an APR
The basic calculation method for an annual percentage rate or APR is to use the measurement known as a periodic rate of periodic interest rate. This formula takes into consideration the number of time periods regularly occurring in any particular calendar year and then multiplies that number by the annual interest rate. A known interest rate will then be added to any known fees, which are divided by the principal (loan amount). The loan amount is subsequently divided by the loan term (days) and multiplied by one year to convert to a percentage (based on 100).
Formula: APR = ((Interest + Fees / Loan Amount) / Loan term)) x 1 year (365 days) x 100 (percent marker)
An example would be if you applied for a $5,000 personal loan with 5% interest to be paid over two years, including a $300 origination fee. This calculated annual percentage rate would require a monthly payment amount based on the following factors:
- Interest rate: 5%
- Origination fees: $300
- Loan Principal: $5,000
- Loan Term : 2 years (24 months)
- Year: 365 days
- Percentage conversion: 100
Calculation of an APR = ((5% + $300 / $5,000) / 2)) x 365 x 100
- Total accrued amount A = (P(1 + RT)
- (1 + 0.05 x 2) = 1.1
- $5,000 x 1.1 = $5,500
- Interest accrued I = A – P
- $5,500 – $5,000 = $500
- A = $500
- Add the accrued interest to loan fees
- $500 + $300 = $800
- The loan amount is divided by the occurring time period as well as by the percentage marker.
- ($800 / $5,000) = 0.1
- 0.1 / 2 x 1 x 100 = 200 = 8%
- Annual Percentage Rate (APR) = 8%
A = total accrued amount, P = principal, R = interest rate, I = Interest accrued and T = time period.
Therefore the annual cost of the borrower’s loan equates to 8% per year interest rate on the total loan amount over the full course of the loan term.
Types of Annual Percentage Rates
There are several different types of annual percentage rates based on various credit categories that you are seeking to be approved for. Some loans or financial products will automatically come with a higher APR, while others will remain extremely competitive.
Below are some of the most common interest rates for typical consumers:
- Variable Annual Percentage Rate – A variable rate is based on a numeric index, known as the prime interest rate that can fluctuate over time. These rates are commonly seen in products such as adjustable rate mortgages, derivatives, and credit cards. Having a rate that can change based on world economic factors may affect keeping a standard budget or contribute to overspending.
- Penalty Annual Percentage Rate – A penalty rate is given when the terms of a credit card or other financial contract are not abided by. This can happen when payment lapses or defaults occur. Typically, a penalty APR lasts for a set amount of time before the contract resumes it’s normal rate.
- Introductory Annual Percentage Rate – Introductory rates are also known as teaser rates which are usually extremely low for a specified period such as the first year or two. Once the initial time frame has been exhausted then the rate increases, often by dozens of percentage points.
- Fixed Annual Percentage Rate – Fixed rates remain stagnant over the full course of the loan. They aren’t sensitive to market swings or financial collapses, which makes them preferable to a wider range of borrowers.
- Cash Advance Annual Percentage Rate – Cash advance rates are much higher than simply using a credit card product or other financial instrument. The interest rate on this type of transaction begins to accrue immediately due to being outside the realm of a normal purchase. There are also fees attached for processing the transaction and cost upwards of 27 percent of your borrowed amount.
- Loan Annual Percentage Rate – Loan annual percentage rates are different from a traditional rate that appears with standardized financial instruments. Aside from the simple interest that accompanies borrowing costs, loans include other items including processing fees, basis points, or insurance premiums.
- Credit Card Annual Percentage Rate – A credit card rate is assigned to credit accounts that are meant to be repaid on a recurring basis or once every thirty days. Carrying forward a balance on the line of credit extended can cause the full rate to be charged. However, an on-time payment that occurs ahead of the cycle due date eliminates the necessity of the additional rate charge.
- Effective Annual Percentage Rate – The effective rate is relative to the actual realized cost of a particular loan or product. As some types of loans such as credit cards use a factor called compound interest, that multiplies on a daily basis versus monthly or annually, the amount due will remain above the advertised rates.
- Nominal Annual Percentage Rate – A nominal rate is another term for simple interest and does not take into account the daily accrued interest charges. An example of a nominal rate would be when interest is paid purely based on the annualized rate calculation.
Annual Percentage Rate (APR) vs Annual Percentage Yield (APY)
Although, in many instances the interest rate may be listed as an annual percentage rate as well as an annual percentage yield, the two terms are not interchangeable. The APR listed on a loan product only documents the simple interest formula in determining the rate in which you will repay the balance.
An APY, on the other hand, will correctly display the amount accrued as a result of compound interest, that will multiply or aggregate on a more frequent schedule such as on a daily basis. In some cases, this can either increase the actual rate or effectively double it over the loan term. Federal financial protections were instituted to highlight the disparities between the two numbers, as they can cause an array of confusion when configuring the direct financial liability.
| Annual Percentage Rate (APR) | Annual Percentage Yield (APY) |
|---|---|
| Heavily advertised as the actual rate | Calculated using simple interest as a factor |
| Accrues on an annual basis | Profit bearing on investments |
| Accounts for simple interest only | Accounts for compounded interest |
| Often lowered for introductory periods | Frequency changes throughout loan term |
APR vs Interest Rate
A basic or nominal interest rate is solely based on the amount of money charged for lending while foregoing any additional fees or inflation adjustments that may be rolled into a loan. As it is commonly lower than other types of rates, borrowers may assume that it is likely the only residual charge aside from the principal balance. Annual percentage rates (APRs) are required to be composed of factors such as simple interest, loan fees, and other seemingly hidden charges. As a result many lenders may focus on the monthly APR rather than market a product that highlights the yearly amount.
Annual Percentage Rate
- Reflects several factors such as interest, fees, and additional charges
- Measures the full cost of borrowing
- Considered a multiplying factor of the standard interest rate
- Higher than a simple interest rate
Interest Rate
- Reflects a principal balance
- Not adjusted via economic inflation
- Determined by alternate method according to financial product used
- Substantially lower than an annual percentage rate
Disadvantages of an APR
Borrowing costs may far exceed advertised or assumed rates, such as annual percentage rates or interest rates. This can come as a disadvantage to those who are unaware of the actual cost associated with loans with fluctuating paydown periods or longer loan terms. Assessing the loan’s true cost based on a variety of payment scenarios or contract terms may eliminate the hurdle of understated or improperly estimated information.
What Affects Your APR?
An APR is affected by several different factors such as the price rate index, down payment amounts, treasury rates, or credit scoring. Additionally, unforeseen lending charges that range from lending fees, closing costs, basis points, or penalty fees can all be components of the exact amount you will be charged upon accepting the conditions of a loan.
What is a Good Annual Percentage Rate?
A good annual percentage rate is one that doesn’t fluctuate wildly over time and accounts for all of a financial product’s fees upfront. Fixed rates are typically more reliable in the long run due to their inability to be changed over the loan’s lifetime. Although many APRs are advertised to be competitive in some cases, it may not be the most ideal for your financial situation. Having a higher credit score or loftier down payment can assist you in being offered a lower rate overall, versus an introductory rate that increases after the first year or two.
Conclusion
Annual percentage rates account for the perceived benefits of entering into a loan contract or other credit agreement. Having a detailed accounting of what actual charges will be incurred over the course of the arrangement will provide a true picture of the value over the long term. Conducting the proper amount of research beforehand can save you from misleading costs, an unsatisfactory experience, and thousands of dollars.
