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What Is APR And Why Does It Matter?

Dan Rafter15-minute read
February 10, 2022

You’re applying for a mortgage, auto loan or personal loan. How do you compare your offers to see which one costs the least? If you’re like many borrowers, you look at the interest rate attached to these loans, searching for the one that is the lowest.

But interest rate isn’t the best way to judge the cost of a loan. A loan with a lower interest rate isn’t always the most affordable because interest rate doesn’t account for the fees that lenders charge to originate loans.

When comparing loans, focus instead on the annual percentage rates attached to them. This figure, better known as APR, gives you much more information on how much a loan will cost you.

“Consumers are often obsessed about their interest rates, but interest rates don't give the whole picture," said Uri Abramson, Co-Founder of OverdraftApps, a web portal that helps consumers make financial decisions about banking, loans and credit cards.

Abramson recommends that borrowers think about what they consider when weighing a job offer. Borrowers don't only think about the salary being offered. Sure, that salary is important, but there are other benefits that can add to your financial wellbeing and make a job offer more attractive. These include healthcare benefits, bonuses, the 401(k) program among other perks.

Abramson says that you should treat a loan's APR the same way.

"Yes, the interest rate is extremely important, but your APR gives you a fuller picture," Abramson said. "APR includes not only the interest rate, but also all charges and fees you're paying to get the loan. Understanding your APR gives you a much more accurate picture of all your loan expenses beyond just the interest rate."

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What Is APR?

You might think that a loan's interest rate and APR are the same thing. But there's a subtle, and important, difference between the two.

Your loan's APR represents how much it costs you to borrow money every year. Like your loan's interest rate, it comes in the form of a percentage. But APR is more inclusive. It includes not just your loan's interest rate but also the origination fees and closing costs that a lender charges.

APR, then, will always be higher than your loan's interest rate. It also gives you a clearer picture of how much your loan costs. In that case, when comparing loans, it's better to judge them by their APR (their total cost) than by their interest rate.

Priyanka Prakash, lending and credit expert at New York City-based Fundera, which provides loans to small businesses, says that APR is one of the most important numbers you'll encounter when taking out a loan.

"APR is the true cost of a loan over one year," Prakash said. "It's important for consumers to understand APR because it allows you to compare the cost of different loan products apples-to-apples."

This is important because lenders often quote their fees in different ways, which can make shopping for the lowest-cost loans difficult. APR, though, gives you a single number on which to focus.

"APR standardizes cost and lets you compare," Prakash added.

What Is The APR Formula?

Calculating the APR on a loan isn’t the easiest of tasks, and if you don’t like math, you might not succeed at trying to do it on your own. It is possible, though. You just need to know some basic information: the fees your lender is charging, the interest you must pay over the life of the loan, the loan's total amount and the number of days in your loan's term.

Once you have that information, here is the formula you can use to calculate the APR on your loan:

Say you are taking out a $2,000 loan and you have 180 days to pay it back. Say, too, that you'll be paying $120 in interest for this loan and your lender is charging you an origination fee of $50. To calculate your APR, first add your origination fee and total interest, $50 plus $120, to get $170.

Next, divide $170 by the total loan amount of $2,000 to get 0.085. Divide that result, 0.085, by the term of the loan, 180 days. That figure comes out to 0.00047222. If you proceed to multiply that number by 365, you get 0.1723603. Now you can multiply that figure by 100 to get your final APR of 17.23%.

Of course, this math can be complicated. However, your lenders should always list the APR of any loan for which you apply. And if you don’t see the APR, be sure to ask. Never agree to a loan unless its APR is spelled out for you.

How Does APR Affect My Payment?

 Your APR directly affects how much you pay to borrow money. Simply put: the higher your APR, the more you’re paying for a loan. This is because your APR represents the combined total of your loan’s interest rate and fees. If your lender charges lower fees for your loan, your total cost of borrowing money will be lower. If your lender charges higher fees, your cost will be higher.

The same holds true for interest rates. If your lender charges you a lower interest rate, the cost of your loan will be lower. If you’re tagged with a higher interest rate, you’ll pay more for this loan.

Mortgage APR Example

Say you’re taking out a 30-year fixed-rate mortgage loan of $225,000. If your interest rate is 4.3% and your closing costs (the fees your lender charges you) are $5,300, your loan's APR is 4.497%. At this APR, your monthly payment will be $1,113.46 not including your property taxes and insurance costs.

 

Now say you are taking out that same 30-year fixed-rate mortgage of $225,000, but your interest rate is 5% and your closing costs are $5,400. Your APR is now 5.21%, boosting your monthly payment to $1,207.85 not including taxes and insurance.

That's a difference of $94.39 a month, or in other terms, more than $1,131 a year. Depending on how long you hang onto your mortgage before selling your home, paying it off or refinancing, that can add up to a lot of extra money.

Auto Loan APR Example

APR works similarly when it comes to auto loans. Say you borrow $17,000 and have 60 months to repay this loan. If your APR is 5%, your monthly payment will be $321. If you take out the same loan but qualify for a lower APR of 4.5%, your monthly payment will instead be $317. 

Credit Card APR Example

Credit cards are a bit different because the interest rate and APR are the same here. This is because there are no fees associated with getting a credit card. 

Your credit card's APR, though, will certainly affect how much you pay in interest if you run up debt that you can't pay off in full each month. Say you owe $5,000 on your credit card at an APR of 19%. If you only make the minimum required payment each month, it will take you more than 11 years to pay off this debt if you don't make any additional charges. You'll end up paying more than $8,136 to pay off that $5,000. Yes, that's more than $3,000 in interest.

What’s The Difference Between Interest Rate And APR?

 Both the interest rate and APR attached to a loan give you key information about how much you'll pay to borrow money, but they don't tell you the same thing.

The interest rate tells you how it costs to borrow your loan's principal amount. If you take out a $200,000 mortgage loan, your interest rate tells you how much your lender is charging you to borrow that amount of money.

On the other hand, your loan's APR tells you how much you'll pay for your entire loan. APR includes your interest rate in addition to other costs charged by your lender and third parties. When taking out a mortgage, this could include the fees you pay for discount points, the closing costs your lender charges and the fees charged by real estate attorneys and title insurers.

If you want to compare how much a loan costs, it's best to review the APRs quoted to you, not just the interest rates.

Despite the importance of APR, Jared Weitz, Chief Executive Officer and Founder of United Capital Source in Great Neck, New York, said that most consumers don't really understand how it works.

"In general, many consumers know APR is important, but don't understand what it actually is encompassing," Weitz said. "Interest rates are clear, but with the added inputs required for understanding, APR seems to bog people down."

Weitz explains APR like this: Say you recently bought a TV. You paid a single price for the appliance, but that price isn't the total that you pay to watch your favorite shows or movies. You might have paid extra for cable, premium channels or streaming services.

The combination of those extra fees and the initial purchase price of your TV represent the total cost of that television. The same is true of APR: It is the total cost of the interest you pay on a loan as well as the fees you pay to get that loan.

Fixed Vs. Variable APR

 There are two types of APRs: fixed and variable.

Fixed-rate APRs are the simpler of the two. As the name suggests, a fixed APR doesn’t fluctuate according to the performance of an outside economic index. A fixed APR provides more certainty: You know what your payment will be each month because your loan's APR doesn't change.

However, this doesn't mean that a fixed APR won't ever change. Sometimes an event will trigger an increase. If this happens, your lender or credit card provider must provide you with a notice that your rate will change. For instance, if you make a late payment on your credit card debt, your provider might increase your APR to what is known as a penalty APR.

Alternatively, a variable APR does fluctuate over time. These APRs are often tied to a specific index interest rate. Often, variable APRs might fluctuate with the performance of the U.S. prime rate, which is the lowest APR that banks charge. Your lender, though, might choose another economic index to tie to your variable-rate loan. Make sure you know which index matters before agreeing to a variable-rate loan.

Your loan agreement will spell out when a variable APR might change, how often it can change and how high it can get. Make sure you understand the terms and that you can afford your monthly loan payment even if your variable APR increases.

Nathan Grant, Credit Industry Analyst with consumer website Credit Card Insider, said that borrowers like variable-rate loans because they typically come with introductory APRs that are lower than what they'd get with standard fixed-rate loans.

However, once a loan enters its adjustment period, borrowers might feel the financial pain as their APR and monthly payment increase. Consumers who haven't budgeted properly for this change might struggle to make their new payments on time each month. This is why it's so important for borrowers to research just what can happen to their variable-rate loans after the fixed period ends and the adjustment period begins.

"Be sure to find out which consumer protections come with your loan, such as interest rate caps, which limit the amount your APR can increase over a particular period of time," Grant said.

Prakash mentioned that variable-rate loans also come with another downside: Their volatile nature makes it difficult to say just how much these loans will cost you over their lifetime, even with the help of APR.

Because the interest rates on variable-rate mortgages vary over time, this means that the APR attached to these loans will fluctuate too. This makes APR far less useful when comparing shopping loans because when applying for a loan you don’t know what its APR might be 5, 7 or 10 years in the future, added Prakash.

Different APRs On Credit Cards

Credit cards are interesting because the APR and interest rate on them are the same. This isn’t the case with other loan types such as student loans, auto loans or mortgages. With these loan products, the APR is higher than the interest rate because the former figure includes fees charged by the lenders behind them.

Credit card companies don’t charge origination or closing fees. Because of this, the APR and interest rate on credit card debt are the same.

That said, this doesn’t mean that credit card APRs can’t get complicated. They actually can because credit cards come with a variety of different APRs, some that are far higher than others.

Purchase APR

Your credit card's purchase APR is what your provider charges you when you make a new purchase with your card. This rate can be high, often ranging from 14.99% to more than 24%. There is good news, though: If you pay off all your credit card debt by its due date each month, you won't have to pay any interest at all on it. If you do this each month, your purchase APR won’t matter. If you carry a balance, though? That purchase APR will kick in. It's why credit card debt tends to grow so quickly.

Penalty AP

Your credit card provider might charge you a penalty APR if you are 60 days or more late on your credit card payment. This APR can be particularly painful, soaring as high as 29.99%. You do have some protections here, though. If you make 6 months of on-time payments, thanks to the Credit CARD Act of 2009 your credit card provider is required to lower the rate on your outstanding balance back to your previous interest rate. However, your provider does have the right to retain your penalty APR on future purchases indefinitely.

Introductory APR

Credit card companies often offer a teaser APR when you first sign up for a credit card. For instance, a provider might offer new customers a 0% APR on new purchases or balance transfers for a year after they open an account. These introductory APRs can be great deals, but remember that they are temporary. After the introductory APR offer expires, your card’s regular APR will kick in. At that point, make sure, if you transfer debt from one card to a second card with a 0% APR introductory offer, that you pay off that debt before the intro period ends.

Balance Transfer APR

This APR is what your provider charges when you transfer debt from one credit card to another. This APR will vary by credit card providers, but many will charge an APR of 3% on balance transfers. Some might even charge either a flat fee of $5 or a 3% APR on the debt consumers transfer, whichever figure is higher.

Many cards also offer 0% APR on balance transfers for new customers. These introductory offers often last for 1 to 2 years. After the introductory offer ends, the card’s standard purchase APR and balance transfer APR will kick in.

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Loans And Their APR

APRs on everything from credit cards to mortgage loans tend to fluctuate over time. Here is a look at how average APRs have risen and fallen during the last 10 years:

Credit Card APRs

Credit card APR

(Source: CreditCards.com)

Student Loan Interest Rates

There are different types of student loans, and the APRs charged will vary depending on whether you are taking out a federal student loan or a private loan. To give you an idea of the interest rates attached to student loans, here is a history of the average fixed interest rate charged for direct subsidized student loans and subsidized federal Stafford loans for undergraduates:

Student loan interest

(Source: Federal Student Aid, U.S. Department of Education)
 

A quick note about the chart above: You’ll notice this chart lists interest rate and not APR. That’s because with federal student loans, your lender deducts its origination fee upfront from your disbursement, keeping APR out of any calculations as to how much your loan costs.

Mortgage Loan Interest Rates

Mortgage loan interest rates have fluctuated since 2009 but have remained at historic lows ever since then. Here's a look at where the average interest rate on 30-year fixed-rate mortgage loans stood at the beginning of each year since 2009. Again, this chart lists average interest rates, not APRs. That's because what lenders and third parties charge in origination fees (which help make up APR) varies. APRs, then, can vary significantly from lender to lender.

Mortgage interest rates graph

(Source: Freddie Mac)

Auto Loan Interest Rates

The APR you pay on an auto loan will depend largely on the term of the loan. Here's a look at average auto loan interest rates for 60-month loans from commercial banks for new automobiles (from the last 10 years). Again, this chart lists interest rates as the origination fees and closing costs from lenders varies.

Auto loan interest rates

Why Is My APR So High?

Perhaps you’re not happy with your credit card’s APR of 20%, or maybe you’re concerned that the APR on your 30-year fixed-rate mortgage loan is 5.2%.

In these cases, your question might be: Why is my APR so high?

Plenty of factors influence your APR: some that are inside your control and others that are outside of it.

The Type Of Loan

Certain loans tend to come with lower APR. Mortgage and auto loans are a good example. That’s because these loans come with less risk to lenders. Both mortgage and car loans come with collateral. If you don’t make your mortgage payments, lenders can take possession of your home through the foreclosure process. If you skip your auto loan payments, they can repossess your car.

Loans that don’t require any collateral on your part, such as personal loans, tend to come with higher APRs because they are riskier for lenders. It’s easier for you to walk away from a personal loan if you’re sure that doing so won’t cost you your home or your car.

Credit cards also come with higher APRs. It’s not unusual to have an APR of 17% or higher with a credit card. Of course, the APR on your credit card won’t matter if you always pay your card’s balance on time each month.

Your Own Credit

Your three-digit credit score is important, too. It shows lenders how well you’ve managed your credit and paid your bills in the past. If your credit score is high, you’ll usually be rewarded with a lower interest rate as well as a lower APR. 

What is a good credit score? Opinions vary, but lenders tend to consider a FICO® Score (the score used by mortgage lenders) of 740 or higher to be especially strong.

Your Debt

Lenders will also look at your debt-to-income ratio (DTI), a figure that shows how much of your gross monthly income that your total monthly debts consume. Again, lenders vary, but most prefer that your total monthly debts equal no more than 43% of your gross monthly income.

 

Generally, a low debt-to-income ratio increases your odds of qualifying for a lower APR.

How To Lower APR On Credit Cards

Upset that your APR is so high on your credit card? Instead of fretting, take action.

First, pay your monthly bills on time. Paying your mortgage, auto, student loans and personal loans on time will boost your three-digit credit score, which will, in turn, boost the odds that you will receive a lower APR. Paying your credit card on time each month will do the same.

Paying down your credit card debt can help you get a better APR too. Again, that’s because lenders like to work with borrowers who have lower debt-to-income ratios. Paying down your credit card debt will help lower your debt-to-income ratio and go a long way toward lowering your APR.

Can you be even more proactive? Can you ask your credit card company for a lower interest rate?

Sure. If you think your APR is too high, you can always call your credit card provider and ask for a lower interest rate. Your provider doesn’t have to comply, but you’ll have a better argument if you have a history of paying your credit card bill on time.

How Does Credit Affect My APR?

Basically, the higher your credit score and the better your credit, the lower the APR you’ll qualify for when you apply for mortgages, credit cards, student loans and auto loans.

Every time you make a financial mistake such as making a late payment on your credit card, your credit score takes a hit. And these mistakes don’t disappear. They stay on your three credit reports for up to 10 years, maintained by credit bureaus Experian, Equifax and TransUnion®.

It’s important to know that the negative impact of these financial mistakes lessens over time. A missed credit card payment might linger on your credit report for 7 years, but the negative drag on your credit score is less as those years pass.

 

The chart below, compiled from information from myFICO.com, shows the most common financial mistakes that can damage your credit score. How far your score will drop after these mistakes vary depending on factors such as your credit score before you made a financial misstep, how much debt you have and whether you’ve applied for several credit cards in the recent past. Know, though, that the financial mistakes listed in the chart below will usually cause your credit score to drop by 100 points or more. As a result, that credit score drop will usually result in a higher APR on loans and credit cards.

Financial mistake recovery chart

(Source: myFICO.com)

It’s important to keep tabs on the health of your credit and to check your credit reports. You are entitled to one free copy of each of your three credit reports once a year, which you can download from AnnualCreditReport.com.

If you want to learn more about your credit score and how it affects your APR, visit Rocket HQSM. We offer plenty of information on how you can monitor your credit reports and the steps you can take to boost your credit score.

Apply Online with Rocket Mortgage®

Get approved with Rocket Mortgage® and do it all online. You can get a real, customizable mortgage solution based on your unique financial situation.

Dan Rafter

Dan Rafter has been writing about personal finance for more than 15 years. He's written for publications ranging from the Chicago Tribune and Washington Post to Wise Bread, RocketMortgage.com and RocketHQ.com.