What Is APR And What Does It Mean For Your Debt?

APR represents the amount of interest that you’re charged on money that your borrow. Whether you’re applying for a new credit card, an auto loan, buying a home, getting a debt consolidation loan, or even going back to school, it’s essential to understand what APR is, how to calculate it, and what it means for your debts.

The APR and interest charged by creditors are how they make their money. It’s essentially the “convenience fee” charged by lenders for allowing you to borrow money. The higher your credit is, the more reliable you are, and the lower your APR will typically be. Conversely, the lower your credit score is, the more of a “risk” you are and the higher your APR will typically be.

Below, we’re going to help you define these often misunderstood terms and explore everything you need to know about calculating APR, reducing APR, and how it affects your debt.

APR and Interest Rates: What You Need To Know

So, let’s start off by clearly defining what APR is. APR is an anagram that stands for Annual Percentage Rate. It’s the yearly (annual) fee charged by creditors and lenders for allowing you to use their money. Sometimes, you may see APR referred to as AIR or Annual Interest Rate, which is the same exact thing. However, APR is the more accepted technical term that most financial institutions and lenders use.

Your interest rates are generally linked to your APR, but they may also include periodic interest rates, which may vary from month to month, depending on your loan status.

Defining Interest Rates

Now that you know some of the basic definitions of the two key terms, it’s time to delve a little bit deeper into interest rates. While they sound a little bit complicated, they’re often misunderstood as there are different types of interest rates that most lenders refer to.

Annual Interest Rate

The annual interest rate (AIR) is essentially the same as the APR. This is the type of interest that we described above and represents the annual fee charged by the lender for borrowing and using their money. For example, if you have a $10,000 loan with a 10% APR, then you’ll pay $1,000 per year until the loan is paid off.

Some lenders offer low-APR or provide no APR for a specific period (usually at the beginning of the loan) to encourage customers to accept the loan or to give them time to make higher payments on the loan itself before paying interest. Other lenders require customers to pay APR from the jump.

Periodic Interest Rate

The periodic interest rate tends to be a little bit more confusing. This is the interest that you pay per billing period. Most loans typically charge higher amounts of interest towards the beginning of the loan and reduce the periodic interest rate as you near the end of the loan. This ensures that they get their “profits” upfront.

How Are Interest Rates Calculated?

For example, let’s go back to our hypothetical $10,000 loan with a 10% APR ($1,000). If your periodic interest rate was divided evenly among the 12 months in a year, then you would pay an extra $83 per month in interest.

However, as we mentioned, the periodic interest is often higher for the first few months. In this case, you may be charged $100 in periodic interest for the first 6 months (periods). This would leave a remaining $400 to be divided across the remaining 6 months in the year. For the last half of the year, you would have a reduced periodic interest payment of $66 per month.

At the end of the year, you would still have paid an APR of $1,000 even though your periodic interest rates would vary from one month to the next. It’s important to understand both terms so that you’re able to budget the right amount of money and don’t fall behind on payments.

What Fees Are Included In Your APR?

When you apply for a loan, you’re not just borrowing the amount that you want. You also have to account for additional costs such as:

  • Fees for processing your loan.
  • Admin fees.
  • Professional underwriting.
  • Document preparation.

The extra amount that this adds to your loan is usually incremental. Instead of charging you all of these fees upfront, though, most lenders just incorporate the fees into your principal balance. For example, your $10,000 loan might even out to $10,200 after all of the fees have been added. Since the lender lets you “borrow” the money to cover the fees, they will be included in your total loan amount and will be included in your annual percentage rate.

These are the typical fees charged when applying for a personal loan, business loan, or credit card. If you’re applying for a home loan through a bank, though, you’ll often have to pay additional fees such as:

  • Escrow charges.
  • Mortgage interest.
  • Fees paid to the broker.
  • Closing costs.

These additional fees should also be included in your APR.

How To Calculate Your APR

APR is a calculation that represents the total percent interest on the loan which you’ve been given. Say, for example, you receive a $10,000 auto loan at an 8% APR (which is a standard APR for decent credit). This means that you would pay an extra $800 per year in interest fees in addition to your normal payments towards the $10,000 principle balance.

Now, let’s just say that your credit wasn’t so great, and you were given a 15% APR on your $10,000 loan. This means that you’d pay an extra $1,500 per year on your loan. See the difference? That’s why it’s so important to try to negotiate a lower APR.

Another key thing to keep in mind about APR is that it’s paid every year. Let’s go back to our example with the $10,000 loan at an 8% interest rate (paying $800 per year in interest fees). If you took 3 years to pay off the loan, then you would pay an extra $2,400 on your loan. As you can see, paying your loan off as quickly as possible is essential if you want to get a great deal.

This is very common in the auto world. Lenders make the most money from borrowers with below-average credit scores. They can give out a $25,000 car loan knowing that they’re going to end up making over $30,000 back at the end of the deal.

How Do Creditors Calculate Your Annual Percentage Rate?

Lenders use a variety of factors to calculate how much APR you’ll be charged on your loan. Ultimately, it all comes down to how much they trust your ability to pay them back and make payments on time. Lenders are looking for assets, not liabilities.

The top 3 factors that determine your APR are:

  • Your credit score.
  • The type of loan you’re getting.
  • The economy.

Your credit score is usually the first thing that comes to mind and represents how financially trustworthy you are. The higher your credit score is, the lower your APR will typically be. The lower your credit score is and the less credit history you have, the higher your APR will be since your chance of not paying the loan back are statistically higher.

The type of loan you’re getting is also important. For instance, home and auto loans generally tend to come with lower interest rates since they are necessities (transportation and shelter). This means that you’re more likely to make timely payments and not fall behind. If you’re getting a personal loan to cover a vacation or recreational vehicle, though, you might be charged a higher interest rate.

Lastly, the economy plays a role in your APR. This can usually be determined by looking at the Federal Reserve’s Prime Interest Rate. Bank interest rates almost always move in correlation with this number. For example, if the economy is good, the Fed raises interest rates to prevent borrowing and inflation. Conversely, if the economy is bad, the Fed lowers interest rates to encourage borrowing and spending to stimulate the economy.

How To Calculate Your Monthly Interest Charges

Calculating your monthly interest fees is relatively easy. Here’s how:

  1. Divide your annual interest rate by 12 (the months/payment periods in a year). This is your periodic interest rate.
  2. Next, multiply your periodic interest rate by the remaining principal in the loan.

The final number you get will show you exactly how much you’ll pay every single month in interest fees. This can be a good exercise to help you stay on top of your finances and payments.

Is My APR Good?

This question largely depends on the type of loan you’re getting. For instance, a 16% APR on a credit card (which is average) would be horrible on a home loan and questionable for an auto loan. Here’s a quick table outlining the average interest rates Americans pay for different loans:

Loan TypeAverage APR Charged
Credit Cards15-17%
Personal Loans8-16%
Car and Auto Loans4-11%
Mortgages (Home Loans)4-7%

How To Lower Your APR

Do you think that the APR you pay is too much? If so, it’s possible to lower your APR as long as you’re willing to do a bit of negotiation. The most straightforward method of lowering your APR is to contact your creditor directly, inform them of the reasons why they should give you a better APR such as:

  • My credit score has significantly improved.
  • I have more assets.
  • I’m willing to make higher monthly payments in exchange for a lower APR.

The best way to lower your APR, though, is to negotiate a lower APR before you sign off on a loan. Changing it when you’ve already paid half of the loan off can be difficult.
Apart from this, one of the most common ways to lower your APR is to refinance your loan. To do this, you’ll apply for another loan designed to pay off your first loan while giving you a better interest rate on the new loan. This can damage your credit short-term (because of the hard pull on your credit) but will save you a lot of money in the long run.