When you’re looking to buy a house, open a savings account, or make any financial agreement that involves interest rates, you’ll have different terms thrown at you. An important term to know and understand is the annual percentage rate or APR.
In this article, we’re going to explain what the annual percentage rate (APR) is and how it differs from the other terms so you can make prudent, informed financial decisions and understand the real costs and benefits of an agreement.
You’ll know exactly how to determine the true cost of a house or loan. This will help you gain control and understanding of your finances and help you plan for the future
Get ready to have your understanding of the financial world taken to the next level.
What is APR?
The APR is the cost of borrowing, or the amount earned with an investment, as expressed as an annual percentage. It takes most costs and fees into account that the nominal interest rate doesn’t, but it doesn’t apply compounding interest into the calculation.
Understanding the APR is critical to figuring out the real cost of any financial agreement that uses interest rates — like loans, credit cards, and savings accounts. By law, all loan issuers and credit card companies are required to provide the APR in any sales or marketing efforts. This gives customers a standard definition for interest rates so they can more easily compare them to competitors’ rates.
How does the APR compare with other interest rates? There are different terms that calculate interest rates differently. We’ll explain the difference between these different terms and provide examples to help you better understand the APR.
Nominal Interest Rates
The nominal interest rate — also referred to as simply the interest rate — only accounts for the amount of interest charged on a loan. It doesn’t account for any costs or fees associated with acquiring the loan (which the APR accounts for).
For example, if you take out a mortgage loan for $100,000 with a 3% rate of interest and pay $4,000 in closing costs and home loan origination fees, your interest rate will differ from your APR. In this example, your annual interest expense would be $3,000 and your monthly payments would be $250. The interest rate would stay at 3% ($3,000 divided by $100,000). The APR, on the other hand, would take into account the $4,000 loan origination fee:
- Add any fees and costs associated with the loan to the principal loan amount ($100,000 + $4,000 = $104,000)
- Use the original interest rate (3%) to calculate the new annual interest expense (0.03 x $104,000 = $3,120)
- Divide the new annual payment by the original loan amount ($3,120 / $100,000 = 3.12%)
As you can see, the APR is higher than the nominal interest rate. This happens because the cost of the loan is higher when you account for interest and other associated costs.
Since the federal Truth in Lending Act requires loan issuers to display the APR, customers can more accurately compare loan costs between competitors. For instance, one issuer may have a lower interest rate but higher origination fees. If they only show the interest rate to prospects, some people would believe it’s a better deal. However, APR may reveal otherwise.
All else being equal — which isn’t always the case as you’ll soon see — the lower APR is the better deal.
Annual Percentage Yield
The annual percentage yield (APY) — also referred to as the effective annual rate (EAR) — gets you even closer to the true total cost of a loan. The APY calculates the true cost of a loan by incorporating compound interest. APR and interest rate calculations only take simple interest into account.
Every time the loan compounds (often once per month), the principal loan amount goes up. While the APR doesn’t take this into account, the APY does.
Let’s say you have a $50,000 personal loan with a 12% APR that compounds once per month. Every month your balance goes up 1% (12% divided by 12 months). This means your total loan after the first month is $50,500. After the second month, you’ll owe $505 as opposed to the $500 you owed the first month; this higher interest payment is reflected in the new, higher principle resulting from compounding.
This compounding effect happens every month, which raises your effective interest to 12.68% (you can check using this effective interest rate calculator). As you can see, when your loan compounds more than once per year, the APY shows you a higher rate that better explains your total cost.
If you want to calculate the APRs — whether that’s a credit card APR, home equity loan APR, or student loan APR — follow these steps:
- Determine the number of compounding periods per year. A compounding period is the number of times interest is calculated and added to the principle of the loan. The contract, loan agreement or marketing documents should tell you what this is. If not, make sure to ask. Often this is 12 (monthly) or 365 (daily).
- Determine the periodic rate. The periodic rate is the interest which is charged over a specific amount of time. If the loan compounds once per month, divide the annual interest rate by 12. If your credit card interest rate is compounded daily, divide the rate by 365.
- Calculate the APY. The formula for calculating the APY is:
- APY = (1 + periodic rate)^# of periods – 1
Let’s look at an example. You have a credit card that charges interest of 21% annually and compounds daily.
- We know the number of compounding periods equals 365 because it compounds daily
- The periodic rate = 0.21 / 365 = 0.05753%
- APY = (1 + 0.0005753)^365 – 1
- APY = 23.36%
As you can see, the compounding effect can significantly increase the amount of interest you pay.
What Else Do I Need to Know?
Your newfound understanding of annual percentage rates will help you make the right financial decisions so you can reach your goal of financial freedom.
We’ve covered a lot, but here are a few more things to understand and pay attention to:
- Watch out for variable APRs. Typically, an APR doesn’t change throughout the life of a loan. This is not the case for variable APRs. They are usually tied to the market, an index, or the U.S. prime rate, and the rate can change on you at any time. If it goes up, you may owe more than you originally planned.
- Your credit score affects the rate you receive. Know what goes into your credit score and do your best to maintain the highest score possible. You can get free credit reports once every year too.
- APRs affect your bank accounts too. All interest bearing accounts — like savings or money-market accounts — are affected by APRs in the same way.
APRs may not be perfect, but they are still very helpful. Imagine shopping for a home loan. Most mortgage rates compound monthly, so comparing different APRs isn’t that difficult. Of course, you can’t just assume this — you want to verify it with the loan officer first.
Here’s a quick recap of what we went through:
- Interest rates don’t take costs and fees associated with procuring the loan into account. They also don’t take compounding interest into account. They simply take the amount owed each year and divide it by the principal amount.
- The APR accounts for the costs and fees associated with acquiring the loan but does not account for compounding interest.
- The APY takes the costs and fees and compounding interest into account.
And here are the calculations:
- Interest rates = amount owed per year divided by principal loan amount
- APR = [Interest rate x (loan amount + costs & fees)] / original loan amount
- APY = (1 + periodic rate)^# of periods – 1
If you want to make the best financial decisions for yourself, don’t rely on loan officers and salespeople to give you the right information. Being self-informed is the optimal way to take control of your financial life.
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