What is APR? Here’s how loan annual percentage rates work (2024)

When reviewing loan offers, the interest rate is perhaps the most important factor to consider since it directly determines the cost of your repayment. But in most cases, the rate you’re seeing is actually an annual percentage rate (APR).

The good news is that a loan’s APR often gives you a more accurate idea of your total borrowing costs — unlike a simple rate, an APR accounts for annualized surcharges. Truly understanding APR’s meaning can help you better evaluate your loan options and ensure you’re getting the best deal possible.

What are annual percentage rates?

The annual percentage rate on a loan is its total annual cost expressed as a percentage. In addition to the loan’s interest rate, the APR also includes other finance charges, such as origination fees, mortgage discount points and other fees.

Depending on the type of loan you’re applying for, you may come across fixed APRs, variable APRs or both:

• Fixed APRs remain the same for the life of the loan, giving you more predictability with your monthly payments. However, fixed APRs usually start higher than variable APRs.
• Variable APRs have two components: a benchmark rate set by an independent organization (such as the prime rate or the Secured Overnight Financing Rate) and a margin rate set by the lender. While the margin typically stays the same, your variable APR can fluctuate as the benchmark rate changes. For you, there’s less predictability and the potential for your rate to increase over time. Still, variable APRs are likely to start lower than fixed APRs — and it’s also possible for them to decrease.

Passed in 1968, the Truth in Lending Act (TILA) requires lenders to disclose a loan’s APR upfront, making it easier for consumers to make apples-to-apples comparisons — it wouldn’t be wise to compare one lender’s interest rate to a competitor’s APR. (TILA also protects consumers from unethical lending practices.)

However, an APR assumes you’ll keep the loan through its full repayment term. Plus, “APR includes loan fees due at the time of funding, which are nearly always nonrefundable if you pay off the loan early,” said Ed Durant, chief credit officer at BHG Financial. So, if you get a mortgage with many upfront costs and sell the home a few years later, your actual APR may be much higher than the one in the loan disclosure.

Good to know: Some lenders may exclude certain fees from the APR calculation, such as non-lender fees, so it’s crucial that you consider more than just the APR to evaluate a loan offer.

So the difference between an APR and an interest rate is…

A loan’s interest rate represents the annual cost of borrowing on a loan. Lenders use interest rates to calculate the portion of your monthly payment that goes toward ongoing interest charges.

But many loans also charge fees when you first take out the loan, such as an origination fee on a personal loan. Fees may be deducted from the loan proceeds, paid out of pocket or rolled into the loan (like with a no-closing-cost mortgage). To account for these additional costs, lenders also provide an APR.

In cases where there are no loan fees, the APR may be the same as the interest rate. Otherwise, the APR is usually higher than the interest rate.

How do APRs work?

Let’s say you want to take out a $15,000 personal loan with a four-year repayment term. One lender offers a 10% interest rate and charges an origination fee totaling 3% of the loan amount, and a second lender offers a 12% interest rate but doesn’t charge an origination fee.

Calculating the APR on the second loan is easy because there are no additional fees to include — the interest rate and the APR are the same.

The first loan, however, is a bit more complicated. You may be tempted to add the 10% and 3% together. However, the lender is spreading the cost of that origination fee over the life of the loan.

Using an online APR calculator (like Calculator.net’s), you’ll find that while the first loan charges an upfront fee, its APR is roughly 12.26%, which is only slightly higher than the 12% APR on the loan with no origination fee.

OK, but what’s the difference between APR and APY?

While the terms APR and annual percentage yield (APY) appear similar, they serve different purposes. More specifically, APYs are used in conjunction with savings products, such as high-yield savings accounts, money market accounts and certificates of deposit.

Banks and credit unions offer interest on your deposits with these accounts, but because they compound the interest you earn, the interest rate doesn’t provide an accurate picture of your potential earnings. APY incorporates this compounding effect to give you a better idea of how much interest you’ll earn in a year.

How to calculate your loan’s APR

While you can use an online calculator to calculate APR on a loan, you can also run the numbers on your own. Here’s the formula for calculating a loan’s APR:

APR = { ((Interest charges + fees / loan amount) / Number of days in the loan term) x 365 } x 100

8 factors affecting your APR

Many factors determine the APR on different types of loans, including:

1. Credit scores: Your scores are an indicator of how well you’ve managed debt in the past. Borrowers with higher credit scores tend to qualify for lower APRs than borrowers with lower scores. It’s wise to check your credit and look for opportunities to increase your scores.
2. Credit history: Even if you have relatively high credit scores, lenders may still view you as a risk if you have certain negative marks on your credit reports. This may include multiple credit inquiries or new accounts in recent months or a bankruptcy or foreclosure, even if it’s been a few years.
3. Debt-to-income ratio: Some lenders have minimum income requirements, but they’ll also calculate your debt-to-income ratio, which is the percentage of your gross monthly income that goes toward monthly debt payments.
4. Loan type: Some loans are inherently more expensive than others. Secured loans, such as auto loans and mortgages, generally offer lower rates than unsecured loans, such as personal loans and student loans.
5. Lender: Each bank, credit union, online company or other financial institution has its own criteria for determining the rates it offers and evaluating creditworthiness.
6. Amount borrowed: The more money you borrow, the higher the risk for a lender. With secured loans, you can minimize your loan amount by borrowing less — for example, choosing a less expensive vehicle (auto loan) or home (mortgage) — or by making a down payment.
7. Loan term: Lenders typically offer lower APRs on loans with shorter repayment terms and higher rates on longer terms.
8. Fees: Just as lenders have different criteria for determining interest rates, they also have unique fee policies. Some personal loan companies, for instance, don’t charge an origination fee, while others may charge a fee as high as 12% of the loan amount. It’s particularly important to pay attention to fees when comparing mortgages because the upfront charges (and closing costs) can be pricey.

What to consider when comparing loan, mortgage APRs

• Other loan terms: Remember, it’s important to compare offers with similar features. For example, one lender may offer a lower APR than another lender — but with a shorter repayment term. While that might not be an issue, you’ll want to make sure you can afford the higher monthly payment. Using an online monthly payment calculator and updating your budget can help you confirm affordability.
• Fees: Some lenders, particularly in the mortgage industry, may charge fees that aren’t included in the APR calculation because they’re not charged by the lender — such as the costs for appraisal, inspection and title transfer. Compare both lender and non-lender fees when you’re shopping around.
• Pre-qualification: Some lenders allow you to get pre-qualified for a loan without impacting your credit scores. While this process can be a great way to evaluate your options, there’s no guarantee that you’ll get that quoted rate in the end. You must submit an official application and undergo a hard credit check to get your final, formal offer.

Wait, what about credit card APRs?

Credit cards fundamentally differ from loans in several ways, including how their APRs work. Here are some of the differences to keep in mind:

• APR vs. interest rate: With loans, the APR is generally higher than the interest rate (unless it’s truly a fee-free product). In contrast, a credit card’s APR and interest rate are virtually always the same.
• Different types of APRs: Credit cards charge different rates for different card uses. For example, there may be a purchase APR, balance transfer APR, cash advance APR and penalty APR if you fall behind on payments. Some cards even offer an introductory low or even 0% APR for a set period.
• Grace periods: Most credit cards offer a grace period between your monthly statement date and due date. If you zero your balance by the latter date, you don’t have to pay any interest.
• Most APRs are variable: While many loans offer fixed and variable APRs, most credit card rates are variable and fluctuate over time.

Remember that a credit card’s APR is just one of many factors to consider when choosing a card. “Promotional offers, rewards programs, grace periods and penalties for late payments or exceeding credit limits aren’t reflected in the APR but can significantly impact the overall cost and value of the financial product,” said Michael Broughton, CEO of credit-building app Altro.