If you have debt or are planning to take on new debt, you must understand the APR. Lenders and creditors give you credit, so you can pay for purchases over time, but they don’t do it for free. The APR is basically the price you pay to borrow and be able to buy, that is, the cost of the convenience that credit provides. And understanding it is often the key to getting out of debt quickly for as little money as possible.
This Debt.com guide will teach you everything you need to know about APR. If you have any questions, visit our Ask the Expert section to consult Debt.com’s panel of experts.
Definition of APR and interest rates
APR is the Annual Percentage Rate and represents the full standard cost of using a credit card or loan. This means that the APR includes not only the interest rate but also the standard financing fees on some loans. So even though the annual percentage rate (APR) and interest rates are interconnected, they are not always identical.
What is an interest rate?
An interest rate represents the cost of debt, not including fees, expressed as a percentage. There are two types of interest rates that matter:
- An annual interest rate is the rate of interest charged for one year. It’s basically the APR, minus the fees.
- A periodic interest rate is the interest rate charged in a single billing cycle. This is the rate you can use to calculate your monthly interest charges.
You multiply the current balance of a loan or credit card, by the periodic interest rate, and you can determine the accumulated monthly interest charges. These charges are deducted from your monthly payment. This means that only part of your monthly payment goes toward principal reduction (the actual debt you owe).
For example, let’s say you have a mortgage for $240,000 at an interest rate of 5%. Your monthly payment would be $1,288.37. However, only $288.37 goes towards the principal payment. The other $1,000 is used to cover accrued monthly interest.
What fees does the APR include?
The APR includes any standard fees on loans. This includes:
- Administration fees
- Loan Processing Fees
- subscription fees
- Document preparation fees.
For mortgages, the APR also includes the following fees:
- prepaid interest
- broker fees
- Private Mortgage Insurance (PMI)
- Escrow Fees
- Some closing costs
However, other fees are not included in the APR, such as appraisal fees, attorney fees, credit report fees, title, and notary fees. Any fees incurred due to payment problems are also not included in the APR. This includes prepayment, prepayment fees, late fees. For credit cards, fees are not included in the APR. Therefore, the credit card’s annual percentage rate (APR) is identical to the annual interest rate, even on cards that have things like annual fees.
How the APR works, and how to calculate interest charges
The APR is expressed as a percentage of the total amount of debt. So, for example, let’s say you take out a $20,000 personal loan at 5% APR. The total cost of that loan to you as the borrower, over one year, would be $1,000. Conversely, let’s say you took out the same $20,000 loan at 20% APR. In this case, the total annual cost would be $4,000.
That’s why you’ll always want to aim for the lowest APR possible on any financed debt. Higher APR means higher costs. It also usually means it will take longer to pay off your debt because more of each payment will go to cover accrued interest charges.
But this means that you can only use the APR to calculate the annual cost of a loan. If you want to calculate your monthly costs, then you need to know the interest rate.
How do lenders determine the APR?
Since APR is the combination of APR and fees, several factors determine the APR you receive on a loan or line of credit.
- What type of loan or line of credit determines what APR applies?
- Your credit score determines what annual interest rate you may qualify to receive.
- Economic conditions, such as the Federal Reserve currently does, for example, which sets its prime interest rate.
The latter is important and is often overlooked. Just because you have great credit doesn’t mean you always get low-interest rates. The Federal Reserve (Fed) raises and lowers the benchmark interest rate (known as the fed funds rate) to help control the economy. In a weak economy, the Fed lowers rates to encourage borrowing. But in a strong economy, they raise rates to fight inflation.
That means right now, as our economy gets stronger, borrowing gets more expensive. If he bought a house at the height of the Great Recession, he got a great deal, because the prime rate was close to zero. But now, as the Fed completes a series of rate hikes to combat inflation, it means loans and lines of credit are getting more expensive.
Calculation of interest charges from interest rates.
If you know the annual interest rate on a loan or credit card, it’s fairly easy to calculate your monthly interest charges.
- First, divide the annual interest rate by the number of billing cycles to determine the periodic interest rate.
- For most types of credit, this means you divide the annual interest rate by 12.
- Then multiply the periodic interest by the current balance (remaining principal)
- This will tell you exactly how much you will pay in accrued monthly interest.
If you subtract interest charges from your monthly payment, this tells you how much principal you pay in one billing cycle. For credit cards, you can use the APR to calculate interest charges because the credit card APR does not include fees. For loans, you may not necessarily be able to use the APR to calculate interest charges, as fees add up.
How to lower the APR
Since the APR is a combination of interest rates and fees, it follows that there are two basic ways to reduce the APR:
- You can negotiate with the lender to eliminate fees that you would normally pay, such as broker commissions.
- You can reduce the annual interest rate applied to the balance.
The more common of the two is to reduce the annual interest rate. Negotiating interest rates should be an essential skill for anyone who uses credit. When you negotiate interest rates on loans, refinance the debt. Just keep in mind that if you refinance a loan, you’ll face another round of fees. For example, if you refinance your mortgage, expect to get another round of closing costs. When negotiating lower credit card rates, simply call the lender to request a rate reduction. There should be no charge for lowering your rate.
You should consider negotiating a lower rate with a lender or creditor each time your credit score improves. You may also want to consider refinancing and negotiating rates if the economy takes a turn and the Federal Reserve lowers its rates again.
- When it comes to loans, you can shop for a new loan on the market, from any lender, when you want to refinance, not just the lender from whom the original loan came.
- On credit cards, you call the creditor’s customer service line to negotiate. The founder of Debt.com has 7 tips on how to negotiate a lower credit card APR that you may find useful