APR (Annual Percentage Rate)

APR
Annual Percentage Rate (APR) is the measure of how much a loan will cost a borrower over the course of one year. It includes the loan’s simple interest rate, as well as any additional fees or charges.

What is APR?

The Annual Percentage Rate, also known as its APR, is a measure of how much a loan or line of credit will cost over the course of a single year. APR is a better measure of a loan’s true cost than the simple interest rate.1

Why is APR used to measure the cost of a loan?

When a borrower takes out a loan or line of credit, they are almost always required to pay back more than the amount they borrowed. The cost of a loan is referred to as “interest.”

This practice serves two purposes: It allows lenders to make a profit from their loans and provides insurance to the lender against the possibility that the borrower will be unable to repay the loan. (For these reasons, no-interest loans are very rare, especially from financial institutions. They are more common when borrowing money informally from friends or family.)

Interest is usually expressed as a certain percentage of the principal, or the amount that’s been loaned. Interest can be charged in two ways: It can be charged as a flat fee, or it can be charged as an interest rate.

With a flat fee, the borrower pays a pre-determined amount that’s oftentimes fixed. For example, a $1,000 personal loan with a 20% interest fee would cost $200. With an interest rate, the loan accrues a certain percentage of the principal over a certain period of time. With most loans and credit cards, the interest rate is determined on a yearly basis. For example, a $1,000 loan with a 20% interest rate would actually accrue $200 for every year that the $1,000 principal was outstanding.2

With most loans, lines of credit and credit cards, the cost of the loan is determined by an interest rate. (Flat-fee interest is more common on short-term payday and title loans.) However, the interest rate might not actually represent the full cost of a given loan, a line of credit, or credit card. Many lending products come with additional fees and charges that can add to the total cost beyond the regular interest rate.

That’s where APR comes in.

How does APR work?

APR is the best way to measure the full cost of a loan. It includes the simple interest rate, but it also accounts for those additional fees and charges. In the United States, lenders are required to disclose the APR for all loans and other lending products according to the terms of the 1968 Truth in Lending Act (TILA).3

For example, a $1,000 loan with a 20% interest rate and a 5% fee, would have an APR of 25%. If you only measured that loan’s interest against the rates for the loans used in previous examples, it would seem like the costs are the same. But by measuring the APR, you can clearly see that this loan has a higher cost than the loans used in the other examples.4

There are two kind of APRs: fixed and variable.

What’s the difference between fixed APRs and variable APRs?

The difference between these two types of APR is fairly simple: fixed APRs remain the same throughout the life of a loan, whereas variable APRs do not.

If a lender wants to raise the rate on a loan with a fixed APR, they must first notify the borrower in writing. And with lending products like lines of credit or credit cards, where the borrower can continue to withdraw funds or use the card to make purchases, the new rate will only apply to funds withdrawn or payments made after the rate was changed.

Variable APRS, on the other hand, can change without the borrower being notified. In many cases, these rates are tied to an interest rate index, also known as a “benchmark interest rate.” These indexes follow the state of the economy and can rise and fall with fluctuations in the market. On such index is the LIBOR index, which stands for the “London Interback Offered Rate.” This index determines the rates that banks use when the make short-term loans to each other. Variable interest rates are also sometimes referred to as “floating interest rates.”

Variable APRs can affect how much a person owes in payments on their loan, line of credit, or credit card. For instance, a rise in the interest rate will lead to a rise in the amount owed in interest, which will lead to a larger payment. However, a dip in the market could lead to a lower interest rate, which would lead to a lower payment.

Fixed APRs provide borrowers with stability, as the cost of their loan will never change without warning. Variable APR’s trade that stability for the possibility of reward: if the variable rates drop, the borrower could end up saving money on their loan. However, that possible reward is not guaranteed, and the borrower risks their variable APR going up, which would lead to them owing more.

How is APR determined?

The APR for a given loan, line of credit, or credit card, will often depend on the creditworthiness of the borrower. The more creditworthy the borrower, the more likely they are to repay their loan. The more likely they are to repay their loan, the lower the APR the lender is willing to offer them.

Remember, APR not only allows the lender to make a profit on the loan; it also allows them to guard against the possibility that the borrower will not be able to afford the loan and will default on their payments.

Since riskier borrowers are less likely to be able to afford their loan and make all their payments, lenders will charge them higher APRs. Otherwise, lenders would run the risk of losing too much money when a percentage of their customers defaulted on their loans. If they lost enough money, the lender would be forced to go out of business.

The specifics of how APR is determined will vary from lender to lender, but there are two factors in determining creditworthiness that will remain the same: the borrower’s credit score and their credit report?

How is creditworthiness determined?

When a person applies for a loan from a bank or other traditional financial institution, the bank will oftentimes request a copy of the borrower’s credit report and credit score to determine whether or not the person qualifies for a loan, and what kind of APR the lender should charge them.

A credit report is a document that tracks a history of credit use. It includes information on how much debt they carry, whether they pay their bills on time, what different kinds of credit they have, whether they have had any collections notices against them, whether or not they’ve ever declared bankruptcy, etc. The information on a person’s credit report usually dates back seven years from the original date that said information was added. (Certain actions, such as bankruptcies, can stick around for longer.) Credit reports are compiled by the three major credit bureaus: Experian, TransUnion, and Equifax.5

A credit score is a three-digit number that takes the information on a person’s credit report and turns it into a three-digit number that expresses their creditworthiness. The most common credit score is the FICO score, which was created by Fair, Isaac & Company in 1989. (The company changed their name to “FICO” in 2003.) The FICO score uses a scale from 300-850, with 300 is the least creditworthy score and 850 being the most creditworthy.6

FICO scores generally fall into the following categories:

RangeQuality
720-850Great Credit
680-719Good Credit
630-679Fair Credit
550-629Subprime Credit
300-549Poor Credit

As the information on a person’s credit report changes, so will their credit score. For instance, if a person pays off their credit card bill, their score will likely go up. Likewise, if a person fails to pay their credit card bill in a timely manner, their score will likely go down.

Traditional lenders use credit reports and credit scores to determine how risky a potential borrower might be. Borrowers who are too risky will have their application for credit denied; borrowers who are somewhat risky will get a loan or credit card with a higher APR’ borrowers who are not risky will receive a loan or credit with a lower APR.

Do all lenders use credit reports and credit scores to determine APR?

However, not all lenders use credit scores and credit reports to determine their APRS. No credit check lenders, such as most payday and title lenders, offer short-term loans with incredibly high APRs of 300% or greater. Those high APRs allow them to lend to people whose poor credit scores shut them out from traditional institutions. However, those rates, alongside many other factors, have led many to label payday loans as “predatory.”7

Soft credit check lenders will run “soft inquiry” on a person’s credit report, which allows them to get an overview of the person’s information without receiving the full report—which, in turn, means that the borrower’s credit score will not be affected.8 Soft credit check lenders also lend to people whose subprime scores mean that they cannot get a loan from a traditional lender, but they are usually a much safer option than no credit check lenders.

How does Amortization affect APR?

Amortization is a process that applies to installment loans—the traditional structure for most personal, mortgage, and auto loans—in which the borrower pays the loan off in a series of regular payments over a pre-determined period of time.

With an amortized installment loan, every single payment that is made goes towards both the principal loan amount and the interest. As more payments are made, the amount that goes towards the principal versus the amount that goes towards the interest changes. Amortized loans come with an amortization schedule that details exactly how these changes are to occur.

With an amortized loans A majority of the loan’s first scheduled payment usually goes towards the interest rate, with only a small percentage of it going towards the principal. But with each sequential payment, slightly less goes towards the interest and slightly more goes towards the principal. By the loan’s final scheduled payment, the vast majority of the payment goes towards paying down the remaining bit of the principal, and only a small percentage is needed to pay off the remaining interest.9

Since every payment made on an amortized loan goes towards paying down the principal loan amount, the amount of money that the loan’s APR accrues grows smaller over time. The percentage rate itself remains the same, but the same percentage of a smaller principal loan amount means a smaller interest charge. This is why amortized loans can save borrowers money over time.

References:

  1. “Annual Percentage Rate – APR” Investopedia. Accessed January 20, 2017. http://www.investopedia.com/terms/a/apr.asp
  2. ”Interest.” Investopedia. Accessed January 20, 2017 from http://www.investopedia.com/terms/i/interest.asp
  3. “CFPB Consumer Laws and Regulations.” Consumer Financial Protection Bureau. Accessed January 20, 2017 from http://files.consumerfinance.gov/f/201306_cfpb_laws-and-regulations_tila-combined-june-2013.pdf
  4. Estrin, Michael. “The Difference Between Your Mortgage Rate and teh Annual Percentage Rate, or APR.” BankRate.com. Accessed January 25, 2017 from http://www.bankrate.com/finance/mortgages/apr-and-interest-rate.aspx
  5. “What is a credit report?” Consumer Financial Protection Bureau. Accessed January 20, 2017 from http://www.consumerfinance.gov/askcfpb/309/what-is-a-credit-report.html
  6. “What is a FICO Score?” Credit.com. Accessed January 20, 2017 from https://www.credit.com/credit-scores/what-does-fico-stand-for-and-what-is-a-fico-credit-score/
  7. “How Payday Loans Work.” Payday Loan Consumer Information. Accessed January 20, 2017. https://www.paydayloaninfo.org/facts#1
  8. “Hard Inquiries and Soft Inquiries.” Credit Karma. Accessed January 20, 2017 from https://www.creditkarma.com/article/hard_inquiries_and_soft_inquiries
  9. “How Amortization Works.” AboutMoney. Accessed January 20, 2017 from https://banking.about.com/od/loans/a/amortization.htm