What Is APR and Why Is It Important?

When applying for loans or credit of any kind, a few terms are thrown around frequently. One of these terms is APR, or annual percentage right. When applying to borrow money from any institution, you can be sure that the term APR is going to be used. That being said, having a good understanding of what an annual percentage rate really is and how it affects you is important.

In this article, we’ll be going over APR, what it is, why it’s important, and how it affects you. Learn more about it here.

What is APR?

By definition, APR stands for annual percentage rate, but what exactly does that mean? An APR is an annual rate charged by lenders for borrowing, or it can mean the annual rate earned if you’re an investor. It’s expressed as an interest rate and calculates how much you’ll be paying on your loan based on the principal amount and what payments you’ll be making throughout the year. It is legally required that lenders disclose to borrowers the APR charged to them when taking out a loan.

Simply put, the annual percentage rate is what you’ll pay in order to be able to borrow money from a lender.

Is APR the Same Thing as an Interest Rate?

An annual percentage rate may commonly be referred to as an interest rate, but it’s a bit more complicated than that. An interest rate is a percentage charged to the borrower based on the principal amount of the money borrowed. It sounds like an APR, right? Well, you’d be partly right.

APR is an interest rate on borrowed money, yes, but it also encapsulates other costs and fees associated with borrowing money from a lender. These fees can be derived by the lender themselves and include closing costs and insurance. If there are no lender fees or additional costs, then an APR can be an interest rate and vice versa, but more often than not, an annual percentage rate reflects more than just an interest rate.

How is APR Calculated?

APR is often calculated by lenders using a standard APR formula, pictured below. Realistically, the formula itself isn’t all that complicated.

If you know the fees and the amount of interest to be paid over the life of the loan, you can calculate APR pretty simply yourself. It’s rare that you’d need to calculate this yourself, as the APR must be disclosed to you by your lender. That being said, you can plug in figures and estimates when trying to determine exactly what you can afford in terms of a loan and the APR associated with it.

Different Types of APR

When it comes to APR, not all annual percentage rates are the same. There are different types of APR that lenders can offer. Some of the different types of APR are only applicable to specific types of loans or credit.

Fixed APR

A fixed APR is generally the most stable APR, as the rate never fluctuates when the agreement is signed between the lender and the borrower. Fixed APRs allow for more predictable budgeting and are often applied to loans like mortgages.

Variable APR

A variable APR changes when an index interest rate does. An index interest rate is a benchmark interest rate that can rise and fall over time. Examples of index interest rates are the prime rate, the London Interbank Offered Rate (LIBOR), and the various U.S. Treasury rates available to the public. 

When the index interest rate that your APR is based on changes, so will the APR. This can be beneficial or detrimental, depending on the way the index interest rate moves. If the rate rises, so will your APR, costing you more money in the long run. If it falls, then your APR will fall as well, saving you money. Variable APR is typically offered on products like credit cards.

Introductory APR

As the name implies, an introductory APR is a line of credit or loan that comes with a lower, limited-time annual percentage rate. The limited amount of time is predetermined and can apply to a specific amount of time, or if referring to a credit card, it can apply to several purchases made.

Penalty APR

If the terms of the loan are violated, you may be subject to a penalty APR. A penalty APR can increase your annual percentage rate for a period of time in the result that a payment is missed or late payment is made. This increase reflects the interest rate going up, as well as any fees related to the discrepancy. Penalty APRs are most commonly seen when reviewing credit card terms and agreements.

What Factors Affect APR?

When borrowers are looking to secure a lender for funds, the lender typically has a set of requirements that have to be met in order for the borrower to be eligible. There are many factors that can affect annual percentage rates, as well as whether or not you’ll be approved for a loan in the first place. 

Lenders want reliable borrowers who they know will make payments on time and will completely satisfy the loan. These factors allow lenders to pick and choose their borrowers and increase APR for higher-risk borrowers and reduce them for reliable candidates. Typically, lenders are looking for high marks in the following areas when selecting a borrower.

Credit Score

The higher your credit score, the better the rate you’ll receive, in most cases. A high credit score typically tells a lender that you’ll satisfy the loan that you are looking to secure in full and that you’ll be prompt about it.

Payment History

While payment history reflects your overall credit score, some lenders will dig a little bit deeper and review the total number of on-time, late, and missing payments a borrower has. If the lender has a tight cash flow, it’ll be important to them that the borrower makes on-time payments every time.

Loan Term

When determining your APR, a loan’s term will often play a significant part. The longer the term of the loan, the higher risk the loan is naturally. With a longer-term loan, you can expect to be saddled with a higher APR than that of a shorter loan.

Financial Viability

With larger loans, lenders will consider how financially stable you are and whether or not your financial circumstances make you an optimal borrower. When applying for large loans, bank statements, proof of income, and the total worth of assets may come into play. 

Loan Shopping for Better APR

When looking to secure a loan from a lender, it is possible to shop around for better annual percentage rates. Typically, in addition to the factors above, lenders have set standards for what they’re able to offer to borrowers when it comes to taking out a loan. 

In most cases, you’ll want to shop around for loans so that you’re able to find the best APR available to you. When applying to two different lenders with the exact same information, the APR offered by each may differ.

Why is APR Important?

Annual percentage rates are one of the most important factors when deciding on a lender when securing a loan. In its simplest definition, APR determines how much a loan is going to cost you to borrow over time. That being said, the different kinds of APR and the way that they’re calculated are two things that have to be taken into consideration.

When looking for a loan, first decide what kind of APR you’re looking for, fixed or variable. With fixed APR, you’ll have predictability. With variable APR, you’ll have the chance at lower rates over the life of the loan. Decide which better suits your needs. Then, be sure to review all of the mentioned factors when it comes to determining your APR. If you review the terms and qualifications published by lenders prior to applying, you may have a good idea of what you’ll be offered.

Of course, be sure to shop around. You don’t want to sign the agreement for the first loan you’re offered. Oftentimes, when you’re looking to secure a loan or a credit card, you’ll be offered different annual percentage rates by different lenders even when applying with identical information. APR is important when it comes to taking out a line of credit, as it will determine exactly how much that line of credit will take out of your pocket. Be sure to get the best APR for you and your circumstances.

 

Sources:

Annual Percentage Rate (APR) Definition 

What Is APR and Why Is It Important?

What Factors Do Lenders Consider When Determining My APR?

What Is APR & How Does It Work?

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