Why is APR important?
Annual Percentage Rate (APR) is the total yearly interest rate made from investments or charged by lenders when you borrow money. Understanding the APR on a loan or investment will help you determine the cost of borrowing money or the expected returns on an investment.
APR, which is always shown as a percentage, is a tool investors can use to assess which investment will have the best payoff. Borrowers, on the other hand, need to know APR to decide which lending option is right for their needs.
How does APR work?
The APR value will always appear as an interest rate. In investments, the APR refers to the annual interest rate that is paid out to investors. For borrowers, the APR is a percentage of the principal amount that will need to be paid to the lender each year.
Lenders are required by U.S. law to disclose the associated APR rates. This is why you see APRs listed on credit card advertisements. It’s well known that lenders will exclude certain fees from their APR calculations, making it somewhat difficult to compare APRs.
What is the formula for APR?
You can calculate the APR by multiplying the periodic interest rate by the number of periods in that given year. The APR value itself does not determine the number of times the rate is charged to the loan balance or total investment amount.
To calculate the APR, you’ll need the following information:
Interest = Total interest amount paid over the life of the loan
Principal = Total loan amount
n = Number of days in the loan term
APR = ((Fees+Interest)/Principal) n * 365 * 100
Is it better to have a high APR or a low APR?
Determining whether an APR is “good” or “bad” can depend on the type of investment product and current economic conditions. In general, borrowers of money will want the lowest possible APR, and investors and lenders will want the highest possible APR. Determining a “good” APR will mean looking at several factors, such as:
- Type of investment or loan
- Competing APRs for similar investment products
- Prime interest set by the central bank
- Borrower’s credit score
Prime interest rates set by the central bank cause the biggest differences in APRs from year to year. For instance, when prime rates are low, lenders will lower APRs on their investment products to attract more investors.
While offers like 0% on a car loan or lease seem appealing, be sure to check whether these interest rates apply to the full length of the repayment process.
What is a good APR for a credit card?
Credit card APRs are typically the first APR schemes people encounter. APRs for credit cards are always advertised by the credit card company but are known to change depending on the type of charge. For instance, the APR charged for purchasing gas may be different from a cash advance on the card.
In general, a good APR for a credit card is below 14%. People getting their first credit card or those with a low credit score will likely have a credit card with an APR of 20% – 24.99%.
Lenders, like credit card companies, will use low introductory APRs as a way to entice new customers. In these situations, new credit card holders may enjoy the first year with 0% APR but then see their APR increase to 20% or more in the second year.
What is the difference between APR and APY?
You may see APRs and APYs mentioned in regard to an investment opportunity or a monetary loan of some sort. While these two terms are related, APR utilizes simple interest while APY incorporates compound interest.
Simple interest is calculated as a fixed percentage of the principal loan or investment amount, and it never changes.
For instance, if an investor invests $10,000 in a bond with a 5% APR, that means the investor will get $500 on an annual basis, simply due to the APR.
Compound interest, used when calculating APY, is a percentage of the principal loan or investment amount plus the interest accrued in previous periods, and therefore, the yearly amount will increase each year instead of staying the same.
For instance, a compound interest loan of $10,000 with an annual interest rate of 5% means that the borrower will pay $500 in the first year. In the second year, the interest owed will be 5% of $10,500 ($10,000 principal loan + $500 interest paid in year 1) for a total of $525. In the third year, the interest payment will be 5% of $11,025 ($10,000 principal loan + $500 interest paid in year 1 + $525 interest paid in year 2) for a total of $551.25
What is a real-life example of APR?
When selling a home, the mortgage closing costs will be much smaller when the costs apply to a 30-year period compared to a 7 to 10-year period. In this case, the original APR on the mortgage will likely account for the closing costs that are added to the monthly payments over time.
APRs will encounter some trouble when dealing with more modern Adjustable-Rate Mortgages (ARMs). Compared to APRs that are based on a constant rate of interest, ARMs will charge a different interest rate that’s usually higher after a fixed period. Because ARMs by nature will have varying interest rates in the future, the associated APR cannot predict the true cost of borrowing money.