If you’ve ever had a credit card, or taken out a loan, you’ve likely seen mention of “APR”, but do you understand exactly what it means? To start, APR stands for “annual percentage rate”, and it’s the annual cost of borrowing money. It not only includes the interest you’ll pay on the loan in a year’s time, but also includes any other fees the lender may charge. Because the APR impacts your bottom line, it’s essential to understand what yours will be, before you apply for a loan, mortgage, or credit card. Let’s take a closer look at the ins and outs of APR, so you can make a better, and more informed, borrowing decision.
APR vs. Annual Percentage Yield (APY)
Confusing APR and APY is an easy thing to do. While APR is an annual reflection of how much you will pay to borrow money, APY is the annual amount you will earn in interest for leaving your money in a financial institution. In other words, APR is typically seen with loans, while APY is typically seen with deposit accounts like savings accounts, money markets, and CDs.
APR vs. Interest Rate
Simply put, APR includes more than just the interest rate you’ll be charged. In addition to being a reflection of the interest you’ll pay within a year, APR also takes into account things like loan origination fees, closing costs, or even insurance. Because of this, the APR is usually higher than the stated interest rate on a loan.
How Lenders Calculate APR
Most lenders use risk-based pricing when determining APR. In other words, they set the APR based on the level of risk they’ll take on by extending credit to you. Some things that can factor into the APR you’re offered include:
- Your credit score
- Your income
- The type of loan you’re applying for
- What the current prime rate is (which is set by the Federal Reserve)
- Any additional fees that the lender will charge for the loan
Congress passed the Truth in Lending Act (TILA) in 1968, which requires lenders to accurately disclose how much a loan will cost the customer in total. This law mandates that lenders be accurate in their disclosure of a loan’s interest rate, payment schedule, and associated fees. Furthermore, it requires all lenders to calculate APR using the same rules. Consumers must also have an opportunity to review the APR before agreeing to take out a loan or credit card.
APR Isn’t Always an Accurate Reflection of the True Cost of Borrowing
Keep in mind that lenders calculate APR based on a set repayment schedule and loan term. Therefore, if you repay your loan early, you may find that your actual APR is different than what was initially stated, especially if the lender assesses any kind of prepayment penalty. Adjustable-rate mortgages can be especially challenging when it comes to calculating an accurate APR.
Also, with a credit card, the true cost of borrowing will depend on how much of a balance you carry. In order to minimize your borrowing costs with a credit card you should do the following:
- Pay your account balances in full each month
- Don’t take on more debt than you can afford
- Avoid cash advances on your credit card
Understanding all of the costs associated with borrowing money can help you budget properly and avoid things like late fees and damage to your credit score. If you are considering taking out a loan, mortgage, or credit card for your borrowing needs, BankFive can help! Contact us today for help navigating your borrowing options and understanding the total costs involved.