What Is Annual Percentage Rate (APR)?
The annual percentage rate (APR) is the annual interest generated by a sum charged to borrowers or paid to investors. APR is a percentage that represents the actual yearly cost of funds over the life of a loan or the income earned on an investment. Learn more about what a business plan is.
This includes any fees or additional costs associated with the transaction but excludes compounding. The APR provides consumers with a single number that they can use to compare lenders, credit cards, and investment products.
Key Takeaways
- An annual percentage rate (APR) is the yearly interest rate charged on a loan or earned on an investment.
- Before any agreement is signed, financial institutions must disclose the APR of a financial instrument.
- To protect consumers from misleading advertising, the APR provides a consistent basis for presenting annual interest rate information.
- Because lenders have a fair amount of leeway in calculating it, an APR may not accurately reflect the actual cost of borrowing.
- APR should not be confused with APY (annual percentage yield), which accounts for interest compounding.
How the Annual Percentage Rate (APR) Works
An interest rate is expressed as an annual percentage rate. It computes what percentage of the principal you’ll pay each year by taking into account factors such as monthly payments. APR is also the annual rate of interest paid on investments that do not account for interest compounding within the year.
The Truth in Lending Act (TILA) of 1968 requires lenders to disclose the annual percentage rate (APR) they charge borrowers. 1 Credit card companies are permitted to advertise monthly interest rates
But they must clearly disclose the APR to customers before they sign an agreement.
Types of APR
Credit card APRs differ depending on the type of charge. The credit card company may charge one interest rate for purchases, another for cash advances, and yet another for balance transfers from another card. Customers are also subject to high penalty APRs if they make late payments or violate other terms of their cardholder agreement. There’s also the introductory APR, which is a low or 0% interest rate offered by many credit card companies to entice new customers to sign up for a card.
Bank loans typically have either fixed or variable APRs. A fixed APR loan has an interest rate that is guaranteed not to change during the loan or credit facility’s term. The interest rate on a variable APR loan can change at any time.
The APR that borrowers are charged is also determined by their credit. Rates for those with excellent credit are significantly lower than rates for those with bad credit.
Annual Percentage Yield vs. APR (APY)
While an APR only considers simple interest, the annual percentage yield (APY) considers compound interest as well. As a result, the APY of a loan is greater than its APR. The greater the difference between the APR and APY, the higher the interest rate—and, to a lesser extent, the shorter the compounding periods.
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