When you compare borrowing money from friends or family to borrowing from a lender, the former seems like a quick and easy option to get the cash you need at no extra cost. The essence of borrowing money from your loved ones is trust and obligation. Still, not everyone may be comfortable approaching their close confidantes and instead choose to borrow money from a credit union, bank, or other lenders by agreeing to pay a pre-decided amount over and above the principal amount borrowed.

If you've applied for a loan before or are exploring your loan options, you might have come across the term Annual Percentage Rate (APR). The borrowing cost that borrowers pay when they get a loan, credit card, or another line of credit is nothing but the APR. However, there's a lot more to the concept of APR that you need to understand to make informed choices about credit. So here are the key things you need to know about APR before applying for any loan.

What Exactly Is An Annual Percentage Rate (APR)?

The Consumer Financial Protection Bureau (CFPB) defines the Annual Percentage Rate (APR) as the yearly cost of borrowing you pay, expressed in percentage value. In the case of installment loans, the APR usually includes the interest rate, up-front fees, and other charges for acquiring the loan. This implies that APR can help borrowers determine the actual cost of a loan per year.

Different lenders might charge different interest rates and fees. As a prudent borrower, you should inquire about the fees included in the APR calculation. Apart from revealing the actual cost of a credit option, APR can facilitate an easy comparison between two or more lenders and their loan options. For instance, if you want to find the best online loan for you, APR can help you get a closer estimate of which loan will cost you the least while offering you the same loan term and amount borrowed, and you can make your choice.

How Does The Annual Percentage Rate Work?

The Truth in Lending Act (TILA), a federal law that governs the calculation and disclosure of APR in the U.S., requires all financial institutions to use the Annual Percentage Rate (APR) as the standard measure of interest charges for loans. In addition, payday lenders have to make the APR available to all their applicants, but the point is that borrowers often don't know how to calculate this percentage.

How Is APR Calculated?

Firstly, it is essential to note that the calculation of APR will be different in the case of credit cards and installment loans. Although credit card providers charge annual and late payment fees, these fees do not affect your APR. For this reason, the APR and the interest rate of a credit card are often the same. On the other hand, most personal loans consider different fees like the origination fee in calculating their annual percentage rate. Late payment fees are generally not included in the APR of a loan.

Below is the formula you can use to compute the APR of a loan that includes fees:

Here's an example of a personal loan to help you understand how to calculate APR better.

Let's say you borrow a loan of $5,000 with a 5% origination fee and an interest rate of 7.34%. Though you get $4,750 deposited in your account after deducting $250 upfront as origination fees, you'll still pay interest on the entire $5,000. With a repayment term of two years, your APR based on the above formula will be 11.87%. You can see that the APR is higher than the interest rate due to the additional cost of the origination fee.

It's also important to note that the annual percentage rate in the above example is the same throughout the entire term of the loan. However, not all APRs remain constant throughout the loan term. Your APR may also increase if you pay off your loan early or choose to refinance your personal loan. This brings us to the two main types of annual percentage rates.

What Are The Types Of APRs?

Your installment loan can either have a fixed or variable APR. Whether your loan has a fixed or a variable APR can significantly affect the cost of borrowing. Hence, you should know what each type of APR entails to help you find the right online loan to suit your budget.

Fixed APR

As the name suggests, fixed APR doesn't change during the loan tenure. This helps you to have a fair idea of your monthly payments, which in turn makes budgeting easier. Fixed APRs are most common in the case of mortgages and personal loans rather than credit cards.

Variable APR

When your APR changes due to the fluctuation in the market interest rates or your credit score, it means you have a variable APR. Usually, you'll find this type of APRs for credit cards, but there are installment loans that have variable APRs too. For this reason, you should check the type of APR applicable to your loan before applying with your lender. Needless to say that budgeting with a variable APR can be challenging.

Apart from fixed and variable APRs, you will find many different kinds of APRs, mainly associated with credit cards or lines of credit. They are purchase APR, balance transfer APR, introductory APR, cash advance APR and penalty APR. Most of them are based on the purpose of using the credit or how you choose to use the credit. You can check with the lender for more clarity on the APR applicable to the loan.

What Factors Influence the Annual Percentage Rate?

Once you find enough information on the type of APR when you take out a loan or a credit card, you should consider the factors that can affect the annual percentage rate offered to you.

Some of the common factors that influence your APR are:

Creditworthiness

Many lenders decide your APR after reviewing your credit history and credit score. Lenders being lenders will always consider your ability to repay the borrowed amount and might offer a loan with a higher APR if your credit history shows that you've missed several payments before.

Debt-To-Income Ratio

The ratio between the amount you owe to your monthly income is called the debt-to-income ratio (DTI). You might have a good and stable income, but you might be spending a large portion of your monthly income on debt payments. Your lender can charge you a higher APR or reject your application if you have a high DTI.

Fees And Other Costs

Since interest and fees combine to form your APR, you might have a higher annual percentage rate if a lender charges hefty fees when taking out a loan. To avoid paying more than anticipated for a loan, check the loan's terms and conditions for any hidden costs before signing your loan agreement.

Prime Lending Rate

As opposed to all the other factors affecting APR, the prime interest rate is the reason you see fluctuations in your variable APR during the loan tenure. Influenced by the Federal Reserve's federal funds rate, the prime rate changes every time the Federal government adjusts interest rates throughout the country.

Type Of Loan

Secured loans typically have lower APR than unsecured ones. Using collateral reduces the risk of the lenders as they have a right to sell the asset in case of a default. With low APR, secured loans are also believed to be easier to qualify for, even with a poor credit score.

As a little tip, you can pre-qualify for a personal loan to know the APR you will likely receive. If the annual percentage rate is higher than expected, you can move to the next best loan option or work to obtain a lower APR.

How To Get a Low APR Loan?

Now that you know the factors that can affect the annual percentage rate, you can take a cue from it and make efforts to lower your APR. Since regulating the prime rate is not in your hands, you can begin by boosting your credit score and reducing your debt-to-income ratio. You can't get a good credit score or DTI overnight. You will have to avoid late payments, exceeding your credit limit, and other things that can negatively affect your credit. Paying off your debt and increasing your monthly income could help lower your DTI. You can refinance your high-interest loan with a lender who provides lower interest rates and reduce your overall loan cost.

Though it is hard to define a good APR in terms of a loan, you can always try looking for a loan with an APR that doesn't put your finances into trouble. Conversely, zero is the best APR a credit card can offer. Credit card providers usually offer 0% APR as a promotional offer to their new customers.

The Final Say

If you're planning to borrow funds, understanding what APR means, how it works, and the factors affecting APR can help you better manage your finances. In addition, knowing whether your loan has a variable and fixed APR can enable you to create a smarter budget. Above all, annual percentage rates are one of the main criteria you want to consider while selecting the right credit option.