What is APR? How the Annual Percentage Rate Affects Your Borrowing Costs

Anyone who has ever seen APR on a commercial, loan mailer, or credit card ad probably knows that the lower the percentage, the better. A 17% APR is way better than a 24% APR, for example. But that number is a lot more complicated, and you should really understand it before signing for any financing.

The annual percentage rate (APR) represents what borrowing costs you each year in interest. With loans, the APR may include fees, but credit card APR typically excludes fees. APR comes in a few varieties, including fixed, variable, and promotional. Each type will make a slightly different dent in your wallet, so it is worth taking some time to learn the ins and outs of them all.

APR, or the Annual Percentage Rate, is the yearly cost of borrowing money. APRs can be fixed, variable, or promotional.

Did reading that description give you an expert understanding of APR? I’m guessing not, but this guide should clear up any misconceptions you may have about the rate in all of its forms. Once you get the hang of it, you can make more confident financial decisions and just might save yourself a pile of cash. 

To get a handle on the cost of your borrowing, you’ve got to understand APR. Think of it as the cost of what you’ll pay each year in interest. It’s only a rough cost, however, because it doesn’t include compounding interest and (for credit cards) additional fees.

It’s kind of like those Halloween costumes that look cool in the picture but don’t come with pants or shoes; what is advertised doesn’t necessarily reflect all of what you get.

APR Types

Now, with various kinds of APRs, the basic formula remains the same; the only thing different is how it applies to your loan or credit card.

Fixed vs. Variable APR: What’s the Difference?

A fixed APR is like having the same old hunting dog at your side — it’s steady and doesn’t change much over time. This makes predicting your payments and budgeting for the long haul much easier.

This works great for long-term loans, such as mortgages, where you want to know exactly how much you’ll pay for years to come.

A variable APR, on the other hand, is akin to the weather: one day, it’s sunny, then the next day, it’s storming. According to index rates, such as the prime interest rate set by the leading banks, variable APRs yo-yo up and down.

Lenders tack on a little something extra, called the margin, to the index interest rate, and there’s your variable APR. When the market takes a turn, so will your variable APR, saving you money or making you cough up more.

How Promotional Rates Work

Credit card introductory promotions usually offer 0% APRs for a limited time. Expect the period to extend from 6 to 18 months before the regular APR resumes.

Once the promotional period expires, you are left with the regular APR, which is always higher. If you’re smart, you can take advantage of these offers, but stay on guard for when that promo rate will kick the bucket so you’re not caught off guard.

Purchase, Balance Transfer, and Cash Advance APRs

The purchase APR kicks in when you don’t pay your entire credit card balance by the due date. This is the most common type of APR. It applies to purchases and depends on your credit score, as well as what the card issuer likes to charge customers.

Most of the time, you won’t have to pay it at all if you pay off your balance within the grace period — usually between 21 and 28 days following the close of the billing cycle.

The balance transfer APR, to no one’s surprise, is charged when you transfer a balance from one card to another. It’s often the same as your purchase APR once any promotional or introductory periods expire. However, it typically carries a transaction fee of 3% to 5%.

Outside the promo period, it doesn’t offer a grace period, so interest accrues immediately.

The APR for cash advances is the highest of the lot and kicks in when you pull cash off your credit card. Interest and fees start stacking up immediately, so unless you are in a bind, it’s best to avoid that one altogether.

How APR is Calculated

APR includes all the fees when the cost of borrowing is other than just the interest alone. This happens in most cases with loans that tack on origination fees, closing costs, and processing fees. For example, suppose you’re getting a mortgage or a personal loan. In that case, the APR will include those extra fees, giving you a glimpse of how much the loan will cost you over time.

Now, regarding credit cards, APR typically doesn’t include fees assessed for things like late payments or balance transfers — it’s just based on the interest for carrying a balance. They’re a bit sneaky that way!

Moreover, APR never includes compounding. It’s a simple interest calculation, so it softballs the true interest cost, especially for credit cards with their typical daily compounding. In other words, APR is a good cost indicator, but compounding interest provides an additional layer of costs that it does not capture.

Long story short, APR gives you a reasonably full picture when dealing with most loans, but on credit cards, you do really want to watch out for those extra charges — fees and compounding — that are not included.

For credit card APRs, we omit the fees from the calculation.

It pays to know about these chickens because they’re coming home to roost the next time you apply for a loan or credit card.

APRs can vary all over the lot, depending on the type of financial product we’re talking about. Knowing their differences will help you pick out your best option when borrowing money.

Credit Cards

Your credit card APR is based on your credit score, the type of card you are applying for, and the issuer’s way of doing things. 

Usually, the higher your credit score, the lower your APR will be. Don’t get too enchanted with those promotional APRs. They will leave you high and dry once the promo period ends.

If you’ve got bad credit, you might be staring down a higher APR, especially with secured credit cards, even though they are less risky to the lender. But hey, a secured card is easy to get, will help you rebuild your credit if you had a rough go of it, and it may come with a lower APR than an unsecured card if you have lousy credit.

Personal Loans

Personal loan APRs depend on your credit score, income, debt-to-income ratio, loan amount, and term.

Lenders just love borrowers who are in good financial health, meaning better scores get better rates. Smaller loans with longer terms may qualify for lower APRs, too, since they are less risky for the lender.

Make sure you shop around for lenders to get the best total cost. Read the fine print for fees and interest. Different lenders charge various APRs, so comparison shopping gives you your best shot at the best deal.

Mortgages

When shopping for a mortgage, focus like a laser on the APR.

It mixes together an interest rate, origination fees, points, and more and then spins them down into a single number that reflects the actual pain level. 

The lower your APR, the more you’ll save over the life of your mortgage. You can lower your APR by shopping around, raising your credit score, and making a bigger down payment.

When it comes to saving money on mortgages, every little bit counts.

Auto Loans

APRs for auto loans depend on your credit score, loan amount, the length of the loan, and what kind of car you’re buying.

The better your credit is, the better your APR will be. New cars often have lower APRs due to deals from manufacturers and dealerships.

Still, some folks can’t afford to buy new and must (or perhaps prefer) to explore the used car lot. Used car APRs tend to be higher, but some dealers are so desperate that they may be willing to cut you a super deal. That’s fine, as long as the vehicle isn’t one step away from the junkyard.

Want the best rate? Improve your credit score, put down a larger down payment, and opt for a shorter term. I advise you to always compare at least a couple of bank, credit union, and online lender offers before you settle on one.

To avoid high APRs, you should use your noggin while shopping for loans and credit products and keep your credit score in good condition. Do your research, compare options, and don’t be afraid to haggle for a better deal. Every percentage point saved is money in your pocket.

Compare Products Before You Apply

Now that you are about to borrow, you’ll probably be better off not taking the first offer that comes your way. It’s better to check with several lenders and compare APRs — you check for the ripest fruit at the grocery, don’t you? Same thing, that’s all I’m saying.

It is smart to stay on top of various kinds of loans that are available and what APRs those competing offers are charging. Then, of course, there are the promotional APRs. They sound sweeter than fresh watermelon, but at the end of the promo period, the APRs can ramp up quicker than moonshine sales on a cold night.

Be sure to check all the fees because they can stack up really fast and increase your borrowing costs more than what you bargained for.

When making financial decisions, not taking APR into consideration is like trying to plow a field with a broken-down mule — you’re just asking for trouble. A lower APR puts more money into your pocket, making those loans and credit cards a lot easier to manage.

The internet has made comparison shopping for loans a lot easier. There are a bunch of websites (none better than BadCredit.org) that’ll give you APR information on dozens and dozens of credit cards and loans. You can also use loan-finder sites, online calculators, and even credit unions to see who’s offering the best rates. By doing your homework comparing APRs, you’ll end up making decisions that smell as sweet as honeysuckle.

Strategies to Reduce Your APR

One of the best ways to lower your APR is by improving your credit score. You can do this by paying your bills on time, whittling down your debt, and staying away from pesky new credit inquiries. The more you can clean up your finances, the better you’ll look to the folks handing out loans.

Another trick is to make sure you always check your credit reports for mistakes. If you see something suspicious, well, don’t just sit there — get ‘em fixed! Keep that credit score in good shape, and lenders won’t think of you as a gamble, which may very well mean lower interest rates.

Now, don’t be afraid to speak with your lender and request they give you a break on that APR. If you have been making timely payments for a year or longer, then you have some fabulous bargaining chips. Use these as the ace up your sleeve to help you see if they will sweeten the deal.

Another winning tactic is to reduce your debt, maybe through a consolidation loan, prior to asking for new money. You can also shift those high-interest balances onto a new credit card that has a 0% APR promo. Doing so will bundle up all your debts and save you a load of interest while you pay it off.

Avoid APR Pitfalls

The one thing you really don’t want to do is fall into the APR trap by not catching the fine print or by misunderstanding promotional rates.

Promotional APR rates look terrific when first presented, but they can jump up faster than a jackrabbit once the intro period runs out. Make sure you know when and how your terms change so you don’t get stuck with holding the bag.

You also have to look out for penalty APRs that can catch you unawares if you make late payments or violate your credit agreement. These rates are higher than last summer’s heatwave and will hike up your borrowing costs in no time.

The best way to avoid penalty APRs is to pay your bills on time and adhere to the terms of your agreement. You may have to read (or have someone read to you) the fine print to find out exactly when and how your lender may adjust your APR upward.

Understanding your APR is just about as important as knowing when to plant your crops. You want to keep your finances under control by not getting buried in a mountain of debt. APR isn’t some obscure number; it’s one of the most important in what it costs to borrow. Understanding your rates empowers you to make better decisions so you can choose loans that won’t bleed you dry.

Job one is to get yourself a lower APR. You can do a few things: work at improving your credit score, compare offers from lenders, and do not be afraid to haggle. Also, you can round up your high-interest debt, like a bunch of stray cattle, and rope it all into a consolidation loan or a balance transfer with a lower APR. If you do all that, you’ll save heaps of money rather than squandering it on interest.

Knowing how APR works will also keep you from stepping into some of the usual traps, like those sweet-looking promotional APRs. Don’t forget about those penalty APRs either; they’ll sneak up on you if you make late payments. Grasping all this information helps you avoid those shocking surprises that may get you into financial trouble.