APR: What Is It and How Does It Work?

Lenders don’t give away money for free. As nice as that might be for those receiving the loan, that’s not how loans work. It costs money to borrow money. This cost is known as the annual percentage rate (APR). An APR is a measure used to determine how much a particular loan will cost.   

In addition to understanding what an APR is, it is important to understand how it works and what it means for your loan. Otherwise, you might end up paying too much for a loan that turned out to be more expensive than you expected. Just because you qualify for a particular APR and loan product doesn’t mean it’s the best choice for you. 

Let’s explore this important piece of information.

HOW APR WORKS 

Why do lenders charge different amounts? Sadly, not all borrowers repay the money they borrowed in accordance with their agreement. Credit score ratings can be lowered if someone makes a habit of making bad credit choices. Bad credit choices indicate to lenders that the borrower is a riskier investment. As a result, they can charge a higher interest rate.  

Even if the borrower defaults on the loan, the lender will suffer fewer financial losses. This is important for both lenders and borrowers. It is possible that lenders will have to raise rates for all borrowers if they begin losing too much money.

On the other hand, credit scores are higher for borrowers who have a track record of paying back their loans. Lenders reward responsible borrowers with lower rates and help them save money when they need a loan.  

APR shows borrowers how much their loan can cost on a yearly basis. This includes both the interest rate and any origination fees or other fees the lender may charge. This provides a more accurate picture of the loan’s total cost. 

HOW DO LENDERS DETERMINE APR?

If you apply for a loan, the lender won’t just pull an APR out of a hat. Instead, they use several factors to determine an APR, including: 

• The type of loan you apply for 
• Your current debt
• Checking your credit report and credit score 

Different lenders use different methods when calculating APRs, which is why you may receive different APRs from the same lender for the same amount and type of loan. This is why you should shop around before accepting an offer.  

The lowest APRs are reserved for those with the highest credit scores. How much of a difference does this make?

Here’s an example. 

Consider someone with a moderately low credit score who wants a $10,000 personal loan and is offered an APR of 11%. During the loan’s life, they can pay $3,045 in interest. They have five years to pay it off. Suppose someone with excellent credit applied for the same loan and received an APR of 7%. When all other factors are equal, they can pay only $1,880, saving $1,165. This is a huge savings!

WHEN APR DOESN’T MATTER 

Often, the APR of a loan product doesn’t matter. If, for example, you are applying for a credit card that you plan to pay off each month in full, the APR may not matter because you won’t pay interest. 

However, you should always keep an eye on it because you never know what will happen in the future. A ridiculously high APR credit card should not be your only option in an emergency.  

This is not the same as an installment loan. The APR matters even if you pay off your loan in full every month. There is no principal to pay off like with a credit card. A loan’s remaining principal is still accruing interest, and your APR is already incorporated into payments.  

WHAT FEES ARE USUALLY INCLUDED IN APR?  

In addition to the APR, lenders often charge other fees and charges. When comparing APRs, keep in mind that lenders calculate it differently. Some lenders may leave out certain fees from the APR, allowing them to offer low APRs to unsuspecting customers. Almost immediately after you sign the dotted line, you learn that their too-good-to-be-true APR might be too good to be true, and you have to pay some upfront fees you weren’t expecting. 

The APR usually includes loan-specific fees such as origination fees, application fees, or processing fees. Extraneous fees, such as late payment fees, are not included. 

WHEN YOU CAN ENCOUNTER APR 

You can run into APR on all types of loan products. Credit cards come with APR, though you won’t have to pay it if you maintain a zero balance. Installment loans like car loans, personal loans, student loans and more all come with APR.  

The APR on mortgages can get rather complicated. Some lenders can include in their APR certain fees required for taking out the loan but not necessarily tied to the loan. This includes charges like an appraisal, attorney or document preparation fees. Other lenders won’t include these fees or might include only some of them.  

Low APRs typically mean higher closing costs and high APRs may come with lower upfront costs. Make sure you read the documentation carefully or ask to have someone explain it to you.  

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