What Is APR? Understanding Loans, Credit Cards and Interest

By Indeed Editorial Team

Updated April 2, 2021 | Published December 7, 2020

Updated April 2, 2021

Published December 7, 2020

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

When borrowing money or accepting credit for a mortgage, credit card, auto loan or promissory note, you may encounter new terms and concepts. It is important to understand the words and phrases related to lending so you know what you're agreeing to before signing any loan documents or credit card offers. In this article, we define APR, how to calculate it and how to use APR to compare different loans. We also discuss more broadly how loans and credit work.

Read more: How to Become Financially Literate

What is APR?

APR, or annual percentage rate, is the total cost you pay on a loan that includes both interest and any additional fees. This amount is annualized, which means calculated over a one-year period. Since APR includes the nominal interest rate plus any additional costs, it is the actual cost of the loaned funds or credit. For instance, if you borrow $1,000 at an interest rate of 5% for a year but have a $50 processing fee added to your loan (1,050 x .05), you'll owe a total repayment of $1,078.01 at year's end.

What is the formula for calculating APR?

To calculate the APR of a loan, you need to consider the principal amount, the length of the loan term and any extra charges the loan will incur in addition to interest.

Here is the annual percentage rate formula:

APR = ((Interest + Fees / Loan amount) / Number of days in loan term) x 365 x 100

To calculate APR, find the interest rate and add any administrative fees, then divide that number by the loan amount (principal). Divide that figure by the total number of days in the loan term, then multiply it by 365 (one year). Multiply that figure by 100 to convert it to a percentage.

Example: Lily borrows $280,000 at a 2.3% interest rate for eight years. The closing administrative cost for the loan is $1,400. To find the APR, first calculate the Interest on this loan using the simple interest formula: A = (P(1+RT), where A = total accrued amount, P = principal, R = interest rate and T = time period.

In this case, P = $280,000, R = 2.3% and T = 5 years. Therefore, A = (280,000(1+0.023x8)), or A = $331,520.

Interest accrued = A - P = $331,520 - $280,000 and interest = $51,520.

Next, add the interest to the closing cost. Using the APR formula, fees + interest = $1,400 + $51,520 = $52,920.

Finally, divide the loan amount and the number of periods, then multiply by 100 to get a percentage.

APR = (52,920/280,000) / 5 x 1 x 100 = 3.8%

The APR on this loan is 3.8%.

From this APR calculation, you can see that even though the interest rate on this loan is advertised as 2.3%, the real annual cost of this loan is 3.8% when all the charges are included.

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Interest rate vs. APR

An advertised interest rate tells you the exact amount of money a lender makes by offering you a loan or extending you credit. It is like a flat fee you pay for the service of borrowing money. APR, with its combination of those lender earnings and other fees like processing charges, late fees, origination fees, closing costs or mortgage insurance, tells you your annualized total cost of the loan or credit you use. That is why the APR of a loan or credit card is almost always higher than the advertised or nominal interest rate.

Read more: What Does Amortization Mean?

APR vs. APY

Not to be confused with APR, APY is an annual percentage yield. The simplest way to distinguish between APRs and APYs is that APR is the interest you pay on something borrowed, while APY is the interest you earn on something invested. Credit cards and mortgages have APRs, while savings accounts and investments have APYs.

Using APR to compare loans

Shopping for the best loan terms or credit card offers can be tricky, but using APRs instead of advertised interest rates can help you determine which deals you want to pursue. Since the federal government requires all lenders to use the same methods to calculate APRs and to disclose that information to borrowers, you can use APRs as a reliable basis to compare different loans and credit offers. You can think of your APR as a bottom-line number to use when you compare like things.

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How do loans and credit work?

A loan or credit arrangement is an agreement in which a lender gives a certain amount of money to a borrower with the promise of repayment over a predetermined time frame. Loans typically include an interest rate and may include other fees and charges that are added to the amount the borrower repays. Credit card purchases, mortgage payments, car leases and student loans are common loan types consumers use to finance purchases instead of paying in cash. The three basic components of a loan or credit agreement are:

Principal: Principal is the amount the lender loans to the borrower. With credit cards, the principal amount is your balance during your billing cycle.

Interest: Interest is the additional value attached to the loan that the borrower repays in addition to the principal. Interest is how the lender makes money on the loan.

Term: The term of a loan is the amount of time over which the borrower repays the loan to the lender. Term details appear in loan documents or credit card user agreements. How long you take to repay a loan or pay off a credit card will affect how much interest you owe and pay.

Read more: Interest Rates: What They Are and How to Calculate Them

What are the two types of loans?

There are two things that differentiate loan types:

Secured loans: A secured loan is a loan that is backed by something valuable, which is known as collateral. When a loan is secured by collateral—a car or a home, for example—the lender can take possession of it if the borrower doesn't meet the conditions of the loan agreement. The most common kinds of secured loans are home mortgages and car loans.

Unsecured loans: An unsecured loan is a loan that does not require any collateral. If the borrower defaults on the loan, the lender has nothing to take in place of the loan amount. The most common types of unsecured loans are credit cards, personal loans and student loans.

What are the types of interest?

There are two types of interest:

Fixed interest: A credit card or loan with a fixed interest rate means the interest rate does not change over the life of the loan or credit agreement. Fixed rates allow you to know exactly what you owe with no unexpected payment amounts.

Variable interest: When credit cards or loans offer variable interest rates, they charge you interest based on a benchmark or index that periodically changes, like the prime interest rate. What you owe with a variable interest loan or credit card is not a constant, so it's helpful to be careful when budgeting your money.

What is an interest rate?

An interest rate is the cost associated with borrowing the principal amount of money you request, expressed as a percentage. Interest rates are also known as advertised interest rates, simple interest rates or nominal interest rates.

How do you calculate simple interest?

You calculate simple interest by multiplying the amount of the principal (P) by the interest rate (I). As an example, if you are going to borrow $15,000 (P) at an advertised interest of 4.25% (I), the resulting interest is P x I, or $15,000 x 0.0425, which equals $675.50. Then you add the $675.50 to the original principal to determine your total repayment of $15,675.50.

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