What Is APR on a Loan and Why Does It Matter?

You are browsing loans online and every lender throws the same three letters at you: APR. Some lenders offer a 6% rate, some say 24%, and a few payday lenders do not even advertise anything very close to 300%.  But what does all this have to do with your wallet?

This article will explain what APR is, how it is determined and why it is important to consider more than just the interest rate. 

What Exactly Is APR?

Annual percentage rate (APR) is the interest rate charged, expressed as a percent, which represents the total cost of borrowing. This is not just the interest rate. It also covers fees, origination charges and any other expenses that lenders charge and add to a loan. 

The simple formula for APR is:

APR = (Fees + Total Interest Paid) / (Principal x Loan Term in Days) x 365 x 100

Example 1: Personal Installment Loan

You borrowed $5,000 from a lender through any Loan's network. 

• Loan Amount (Principal): $5,000
• Loan Term: 1 year (365 days)
• Annual Interest Rate: 10%
• Origination Fee: $150

Step 1: For step 1, calculate the interest paid over 1 year. 

Interest = $5,000 x 10% = $500

Step 2: Add the fee

Total Cost = $500 + $150 = $650

Step 3: Use the formula for the APR. 

APR = ($650 / $5,000 / 365) x 365 x 100 = 13%

Example 2: Short-Term Payday Loan

Now look at a small short-term loan to see how APR can look very different:

• Loan Amount: $300
• Loan Term: 14 days
• Lender Fee: $45

APR Calculation: ($45 / $300 / 14) x 365 x 100 = 391%

This is an extremely high APR. The fee amount of $45 is relatively insignificant. However, when you annualize it over an entire year, borrowing may seem like a huge deal. That is the purpose of the disclosure of APR. It sets all loans in the same calendar so that you can do a level comparison of the loans. 

APR vs. Interest Rate: What Is the Difference?

Owning a business is a different story, since many borrowers often mix up these two. Let's make an easy comparison: 

Types of APR You Should Know

• Fixed APR: The interest rate will remain constant throughout the life of the loan. Typically, personal loans and installment loans have fixed rates of interest. 
• Variable APR: The rate can go up or down based on a market index, like the prime rate. 
• Nominal APR: The stated annual rate without compounding effects factored in. This is what most lenders advertise.
• Effective APR: Also known as EAR, this will reflect compounding and will provide a more accurate representation of the actual annual cost. It is generally slightly higher than the stated APR. 

Typical APR Ranges for Common USA Loan Types

Why APR Matters When You Borrow

Before signing anything, here are the most important points to keep in mind about APR: 

• It reveals the true cost of borrowing, beyond the lender's advertised, large print rate.
• It enables you to compare two completely different loans side by side.
• It guards you against any hidden fees that may not be disclosed until after you have paid it back.
• It assists you in spending correctly and understanding precisely how much you will be paying over time.
• You must comply with U.S. law. 

What are the options for getting a lower APR? 

The APR is the interest rate set by the lender depending upon the risk. People with lower risk as borrowers typically will have a lower APR. Here is what helps: 

• Pay bills on time and/or keep debt balances low to boost credit scores.
• Only borrow what you require. Loans can sometimes offer a better rate of return on a smaller loan.
• If possible, select a shorter loan period since this might save in total interest to be paid.
• Do some research and shop around to compare several lenders.
• Get a platform that provides you a chance to interact with a lot of lenders simultaneously, and that way you will be able to view your opportunity in one place. 

Frequently Asked Questions (FAQs)

Q1. Does it always make sense to choose a lower APR?

Yes, in most cases. A lower APR will result in a lower total cost for borrowing the same amount of money. But a loan that has a little bit higher APR, but has more flexible payment terms may be more suitable for your situation. Read the entire conditions and terms. 

Q2. Is it possible to increase or decrease the APR after loan issuance?

For a fixed APR loan, this won't affect that loan at all. APR will increase or decrease based on the benchmark rate that the loan is tied to if you have a variable APR loan. Please read before signing! 

Q3. If a lender has a high APR, is the lender a scammer? 

Not necessarily. The reason that short-term loans such as payday loans have such a high APR is that they are intended for short-term loans. The APR formula works by converting the short-term fee into an annualized figure, which makes it seem like a huge fee. 

Conclusion

APR is more than just a number. It's the best way to see the actual cost of a loan. The APR will provide you with information about the actual cost to borrow, whether you are taking out a $500 loan for a car repair or a $20,000 loan for home improvement.

When you're next comparing loan offers, you don't need to wade through the pricing and interest rates, just go straight to the APR column. It will help you filter through the clutter and let you know which deal is less expensive for your budget.