What Is APR, and Why Does It Matter?

How Credit Can Be Useful and Risky

Credit is when you borrow money from someone or a company and promise to pay it back later with some extra money. The extra money is called interest, which is the cost of borrowing.

Credit can be useful when you need to pay for something important, like education, a car, or a house, and you do not have enough money. Credit can also help you build a good credit history, which shows that you are responsible and trustworthy with money. This can help you get better credit terms in the future, such as lower interest rates or higher credit limits.

However, credit can also be risky if you borrow more than you can afford or fail to pay it back on time. If you miss a payment or deadline, you may owe extra fees or penalties, which can increase the interest and the total amount you owe. This can hurt your credit score, the number that reflects how well you manage your credit. A low credit score can make it harder to get credit or other financial services, such as insurance, renting, or utilities.

If you do not pay back your credit, you may face legal action or lose the property you used as collateral.

Factors That Affect the Cost of Borrowing

The cost of borrowing depends on several factors, such as:

• The Interest Rate is the percentage of the amount you borrow that you have to pay as interest. The higher the interest rate, the more expensive the credit is.
  
  
• The Principal is the amount you borrow. The higher the principal, the more interest you have to pay.
  
  
• The Term is how long you have to repay the credit. The longer the term, the more interest you have to pay.

To compare the cost of different credit options, you can use a concept called APR, which stands for annual percentage rate. APR is the interest rate plus any other fees or charges that you have to pay for the credit in a year. APR shows you the true cost of borrowing, and it helps you shop around for the best deal.

Typical APR Ranges

There are many types of credit sources that you can use for different purposes.

Disclaimer: APR varies depending on what type of loan you are applying for. For example, credit cards typically charge higher interest rates than mortgage or auto loans. This is because credit card loans are typically unsecured, meaning the lender has no collateral to take if the borrower defaults on the loan.

Mortgage and auto loans, on the other hand, are secured by the property or vehicle being financed. The lender has the option to repossess the property or vehicle if the borrower does not make their payments. Consequently, mortgage and auto loans are less risky for lenders, so they typically charge lower interest rates.

The rates themselves have a wide range (such as personal loans 5.99% – 35.99%). This is mostly based on credit score – the better the credit score, the lower the APR. Sometimes the APR changes depending on the amount being borrowed. So if you are taking out a big loan, the lender might offer you a lower APR than if you are borrowing a small amount.

APR: How It is Calculated and the Types

APR is calculated by dividing the total amount of interest and fees that you have to pay for the credit in a year by the average balance that you owe.

$\text{APR = } \frac{\text{Total interest and fees in a year}}{\text{Average balance owed}}$

APR includes the interest rate and any other fees or charges that are mandatory or upfront, such as origintion, closing, or annual fees. APR does not include any taxes, insurance, or charges that are optional or contingent, such as late payment, cash advance, balance transfer, or prepayment fees. APR also does not include any benefits or discounts that may reduce the cost of borrowing, such as rewards or cash back.

There are two types of APR that you may encounter: nominal and effective.

Nominal APR is the interest rate that does not account for the compounding frequency, which is how often the interest is calculated and added to the balance. Nominal APR is what is typically listed on your loan application and statements.

Effective APR is the interest rate that accounts for the compounding frequency and shows you the actual interest cost. The more frequently the interest is compounded, the higher the effective APR. For example, if you borrow $100 with a nominal APR of ‍12 percent and a monthly compounding frequency, you will pay ‍$12.68 in interest in a year, and your effective APR will be 12.68 percent.

However, if you borrow the same amount with the same nominal APR but a daily compounding frequency, you will pay $12.75 in interest in a year, and your effective APR will be 12.75 percent.

Additional APR Terminology

You should know several other terms related to APR. These include fixed versus variable interest rates, grace periods, and additional fees, such as late payment, cash advance, and prepayment penalties.

A Fixed Interest Rate stays the same for the entire term of the loan; a Variable Interest Rate can change based on market conditions.

A Grace Period is the amount of time given to the borrower before any payments are due, fees, or penalties are added. It gives borrowers an extra window of time to make their payments without being penalized. For credit cards, it is the time period before interest is added to the balance.

A Late Payment Fee is charged when you do not pay your bill on time.

A Cash Advance Fee occurs when you use your credit card to get cash, like at an ATM.

Prepayment Penalties are fees you may have to pay if you pay off a loan earlier than expected.

Additional fees can add to the cost of borrowing, so it is important to be aware of them and try to avoid them if possible.

Conclusion

When you are in the market for credit, be sure to shop around for the best APR. Do not just look at the interest rate, but consider any fees that might be associated with the loan as well. The APR is arguably the best way to compare apples to apples regarding credit, so use it to your advantage.

Finally, before signing any loan agreement, read the fine print carefully and ask about any hidden fees or penalties. Being an educated borrower will save you time and money in the long run.

Source: Khan Academy, https://www.khanacademy.org/college-careers-more/financial-literacy/xa6995ea67a8e9fdd:loans-and-debt/xa6995ea67a8e9fdd:terms-of-borrowing/a/what-is-apr-and-why-does-it-matter
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