The annual percentage rate, or APR, is the yearly amount that must be paid by a borrower in order to maintain and to pay off a loan. APRs are the commonly used terminology when discussing the annual rate of credit cards, lines of credit, auto loans and leases, and mortgages and other real estate loans.
Regardless of how you’re borrowing money, like with a loan or a credit card, it’s important to know how interest rates are determined. Generally, banks and lenders will look at your credit score. High scores mean borrows can access the lowest APR. Borrowers with low credit scores carry more risk, so their rates are typically higher.
Types of APR
With mortgages and other loans, most of the time, what you see is what you get—the APR is the APR. But if you’re looking at financial products like a personal loan or credit card, you might see a few different types of APR. Here’s what they mean.
Purchase APR: This is the standard credit card APR. In other words, this is the APR that will be applied to all of your purchases if they aren’t paid off by the time your grace period expires.
Introductory APR: Some card issuers offer a low introductory APR. For instance, you might be offered zero percent APR for 18 months. (Be warned: Depending on the fine print, interest may be charged retroactively from date of purchase if you don’t pay off your card by the time your introductory period expires.)
Balance transfer APR: Want to move the balance of another credit card or loan onto this credit card? You’ll pay the balance transfer APR on the balance. Many credit cards offer a promotional balance transfer APR—sometimes as low as zero percent.
Cash advance APR: This is the rate used if you borrow cash from your credit card—for instance, if you take out money via an ATM. Expect this rate to be higher than the usual APR rate. Additionally, there isn’t usually a grace period.
APR vs. interest rates
While APR and the stated annual interest rate on a loan may sound like the same thing, they actually have key differences. The interest rate shown on a loan is what the lender will charge you in interest per year on the outstanding balance (for a loan) or the current borrowings (on a line of credit). But the APR includes not just this raw interest cost, but any and all other fees and costs associated with a borrower actually holding the debt.
These fees include annual charges, customer service fees, closing costs, broker/agent fees, and rebates and discounts. Because of this, when comparing two loans apple-to-apples, it’s best practice to use the APR for both. If you don’t know the APR—even though it should always be prominently stated by the lender—you’ll want to calculate it yourself to give a level view of your choices.
Variable APR vs. fixed APR
APR is typically given as a variable rate or a fixed rate. Typically, things like mortgage loans come with a fixed rate—this means that your APR won’t change over the life of the loan. However, certain types of loans and other types of credit come with variable APR. This means your lender can adjust your rate depending on market conditions.
Variable rates are often changed based on the prime rate. That’s the interest rate that financial institutions use to establish all sorts of rates. For fixed-rate loans, the prime rate only matters at the time the loan is initiated—so if the U.S. prime rate is higher, you’ll have a higher APR.
Calculating APR for mortgages
For mortgages, APR calculations are intuitive:
(Total nominal interest costs + any additional fees and expenses) – (rebates, discounts, or points) / the principal amount of the loan or the available line of credit.
This is your APR. The APR will almost always be higher than the stated interest rate on the loan, unless you’re getting some pretty massive discounts, because it includes the total cost of everything rolled into the loan.
For home buyers, there are always costs outside the nominal mortgage interest paid on the loan. Many of these costs are incurred at the time of initial purchase. As such, most borrowers have those costs “rolled up” into the total amount of the loan to arrive at a new mortgage amount, or principal, which is higher than the money needed to actually buy the home.
The full balance of closing costs, mortgage insurance, and loan origination fees may total $5,000 to $15,000 on a home purchase—more than most are prepared to pay out of pocket. The final mortgage balance after all the fees and costs is the new amount used to calculate the APR.
Mortgage APR: An example
A borrower takes out a $300,000 mortgage to buy a $300,000 home, putting zero percent down. The stated mortgage interest rate is five percent, which equates to $15,000 in annual interest, or $1,250 per month.
But if closing costs of $8,000 were rolled into the mortgage, the final principal amount would go to $308,000. The five percent interest is then calculated on this new amount, totaling $15,4000 per year, or $1,283.33 per month. The APR would be equal to $15,4000 divided by $300,000— or 5.13 percent.
APR and credit cards
With credit cards, interest is assessed daily. Credit card companies determine how much to charge you by dividing your APR by 365. If you have a 23 percent APR, for example, your daily interest would be 0.00063 percent. (.23/365) Assuming you pay off your credit card in full each month (or by the end of the grace period), the APR and interest rates don’t matter.
However, if you carry a balance on your credit card—that means you have leftover spending from the previous cycle you haven’t yet paid off after the grace period ends—the APR does come into play. Let’s say you have a $200 balance, and that same 23 percent APR. After the grace period, 13 cents will be added to your balance the next day as an interest charge. This will happen every day until the card is paid off. Because the balance is slowly increasing due to the added interest payments, the amount of interest will increase on a daily basis, too.
While the APR can be helpful when comparing loans and products from different lenders, it does have some pesky limitations.
For one, there may not be consistency in what fees or costs are included in an APR from one lender to another. In the case of a mortgage, there may not be a consistent approach to how things like title fees, appraisals, insurance, document fees, and notary/attorney fees are incorporated into the APR.
To help filter through different lenders’ reporting standards, we recommend leaning most heavily on the stated interest rate. The headline rate is the most important cost component over the life of the loan, as it’s the amount you’re being charged on the remaining principal balance each month. If loans from two lenders have the same stated interest rate but different APRs, the one with the lower APR is most likely the best value, as it has fewer fees and costs to the borrower.
But again, take the time to dig into the fine print to see if there’s a major cost factor not being incorporated into the stated APR.
Also, the APR will change when someone prepays a loan, pays more than the stated monthly payment, or completely refinances (and thus closes out) the original loan. In most cases, prepayment causes the APR to rise, although many people see value in prepaying anyway—either because a lower rate is available via refinance or just for the peace of mind of squaring away a debt.
How to find the APR
Just ask your lender. Any credit card, auto loan, or mortgage product must provide you with an APR, along with all of the fees and costs included in its calculation. Read the information carefully, including what potential fees and costs are not included—often penalty fees, like late fees. While far from perfect, the APR is a good early signpost to the real-world costs of holding that debt.