Unless you’ve just woken up from a 100-year sleep, you’ve heard the phrase “APR” mentioned in countless car commercials, radio ads for home loans, credit card offers, and other forms of communication. But what does APR mean exactly?
Well, there’s the short answer and the long answer. The short answer is that APR stands for “Annual Percentage Rate.” But you probably already knew that. Let’s dig a little deeper to find out how it works.
Interest Rate vs. APR
Borrowing money can be expensive. Whoever you choose to borrow from will want some compensation in return. Usually, they’ll charge you an interest rate, which requires that you pay them a certain percentage of the principal (the amount you borrowed) at certain intervals. But the interest rate doesn’t specify exactly how much interest they can expect to receive from you on a yearly basis in return for lending you their money. And that’s what APR measures – the agreed upon yearly rate of return on the money that’s been borrowed.
However, it gets slightly more complicated. With most consumer financial products there are some other factors that play a role in what your APR will be. One of those factors is whether you have a fixed or variable interest rate:
- A fixed rate means that the company lending you money has agreed to hold your interest rate steady at a level you agreed to when you initially borrowed the money (or signed the contract).
- A variable rate means that the company reserves the right to raise your interest rate depending on certain external factors, such as the prime rate. Keep in mind that even if you have a fixed rate, your rate can still be increased if you break your part of the agreement (i.e. if you make a late payment).
The other thing that determines how your APR works is whether we’re talking about a credit card a mortgage, a car loan, or some other type of financial product. Below, we’ll explain how APR works for each type of credit…
What does APR mean for credit cards?
When you have a credit card, you only have to pay interest if you don’t pay your full statement balance for each billing cycle. That means you can have a credit card without paying any interest as long as you always pay your bill in full! However, if you go at least one billing cycle without paying the full balance, you’ll begin to be charged interest immediately (see below). And of course, even when you’re always paying your full amount, you might still be charged fees – so check your credit agreement.
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Once you’re in a position where you’re not paying in full and you’re carrying a balance from month to month, you’ll be charged interest on a daily basis – that’s right, a daily basis! Most credit cards calculate your monthly finance charges based on a method known as Average Daily Balance (ADB). To calculate your ADB, add up your balance at the end of each day of your billing cycle and divide that sum by the number of days in your billing cycle. Then, use your APR (written as a decimal) to determine what your finance charges will be, using this equation:
ADB x APR x Number of days in billing cycle / 365 = Your monthly finance charge
This calculation means that it’s always better to make payments as soon as possible toward your credit card balance. If you have a check for $1,000 that you want to use to pay off credit card debt, you should send it in immediately rather than wait until you receive your next billing statement. Otherwise, your average daily balance for that period would be higher than it needed to be – resulting in more finance charges for you.
(See our article How Does Credit Card Interest Work? for more information)
What does APR mean when buying a car?
An APR on an auto loan works similarly to an APR on a credit card, with the main difference being that your auto loan is an “installment” debt (the amount and repayment period are set in your contract) while your credit card balance is a “revolving” debt (the amount depends on how much you spend and how much you decide to pay off). Just remember that everything is negotiable when it comes to buying a car, including the APR.
When you are going over the financing options with the dealership, they may try to add 2-3% onto your APR beyond what’s necessary, and that extra amount will go directly to them (i.e. a nice little commission)1, so you should always do research beforehand and be prepared to show them competitive rates from your local bank or credit union to prevent them from jacking up your APR. And be ready to back up your promise to get the loan from the bank instead of the dealership if they don’t make a fair offer.
What does APR mean when buying a home? (Mortgage APR)
If you’re planning to buy a home or already have a mortgage, you need to understand what an APR means in this context. In essence, the APR for a mortgage includes all costs you pay (including origination fees, etc.) so that you have an idea of how much you’re paying on a yearly basis to own the house. This is different from the interest rate, which only tells you how much interest you must pay on the principal each month – but doesn’t include fees.
For example, if your mortgage loan is for $300,000 and you pay $8,000 in costs associated with getting the loan, then usually the $8,000 is taken from the loan – meaning your loan is actually providing you with $292,000 while your monthly payments reflect a loan amount of $300,000. Since your interest rate does not reflect those extra costs, it’s important to pay attention to your APR because it will tell you how much you’re paying in total – including the extra costs. That’s important to know when you’re comparing different mortgage rates.
What Does 0% APR Mean?
Many advertisements for credit cards and auto loans these days proudly announce that they have a 0% APR (for an introductory period).
So what does 0% introductory APR on a credit card mean? Well, it does mean you can avoid paying finance charges during the introductory period, but you won’t avoid finance charges unless you pay off your balance in full before the end of the introductory period. If you don’t, then you’ll be charged interest on the remaining balance. Also, if you are late on your payment during the introductory period, then the 0% APR is nullified and you’ll be stuck with their regular APR which is probably 15% or higher.
Also, keep in mind that only a select group of people are eligible for the 0% APR offers. You must have a good credit score, and for car buying you often must have a significant down payment – of at least 10%.
If you see a car commercial promoting one of these 0% offers and then you go to the dealership ready to sign on the dotted line, you may be surprised to find out that the 0% APR is not available to you. But once you’re there, the sales rep will surely be happy to sell you a car anyway, whether it’s in your best interest or not!
So approach 0% APR offers with a healthy dose of skepticism. If you’re eligible, and if you are confident you’ll be able to pay on time each month, then it’s probably a good deal for you. Otherwise, try to avoid getting caught up in the “hype” and signing up for something that will cost you a lot of money in the long run.
Knowing how APR works will give you the financial aptitude to make good decisions when getting a credit card, taking out a mortgage, or applying for a car loan. It will also help you avoid any 0% APR offers that might not be legitimate or trustworthy.
If you have any further questions about APR, feel free to let us know in the comments section below.
This article is part of our Credit Card Debt Resource Center. If you’re looking for additional information about credit card debt, be sure to pay a visit!