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Annual Percentage Rate (APR)

The annual rate of interest paid on a loan

What is the Annual Percentage Rate (APR)?

The Annual Percentage Rate (APR) is the yearly rate of interest that an individual must pay on a loan. APR is used on everything from mortgages and car loans to credit cards. Ultimately, APR is the simple percentage term used to express the numerical amount paid by an individual yearly for the privilege of borrowing money.

 

Annual Percentage Rate

 

How APR Works

Every time an individual borrows money in a traditional loan sense (think borrowing to purchase a house, car, or other major financial expense), there is a cost for the privilege of borrowing money, known as interest. APR is the percentage of interest the individual must pay on the loan, which ultimately adds up to the total cost of the loan.

Let’s consider an example to explain the concept further. An individual takes out a $25,000 loan to buy a car. The loan comes with a fixed APR of 5% and must be paid back over the course of five years. It means that the individual will need to make regular monthly payments of around $471.

However, the monthly payment is used towards both paying back the principal loan amount, as well as the interest. The monthly amount remains the same, but the breakdown (or what percentage of the amount goes toward the principal and what percentage goes toward the interest) changes as more payments are made.

As the individual progresses through the payments over the course of five years, the yearly amount paid in interest changes. In our example, the individual begins by paying $1,500 per year in interest, but the amount will change after another year of payments. In the end, the individual ends up paying $28,306.88 total: repayment of the principal of the $25,000 loan and $3,306.88 in interest.

 

Fixed APR vs. Variable APR

In the example above, the 5% APR was fixed. It means that the APR remains constant throughout the entire term of the loan. Fixed APRs can change. They’re not tied to any index, and the change isn’t automatic. A lender is required to give advance notice to the borrower if the APR is going to change.

The lender has the prerogative to adjust the APR to better suit market changes or if the borrower fails to make payments on time, but they must let the borrower know that changes are going to occur and why. Fixed APRs are most common with credit card “loans” or borrowing and is often used as an introductory interest rate before being switched to variable APRs.

Variable APR, then, means just the opposite of fixed APR. Variable APRs are inconsistent and fluctuate – sometimes considerably. In the US, variable APRs are typically affixed to the prime rate index, meaning as the prime interest rates change, the APR will change. The prime rate index is set to match the Federal funds rate established by the Federal Reserve. It means that any time the Federal government adjusts interest rates throughout the country, the variable APR will change accordingly.

 

Final Word

It’s important for any individual who borrows money to understand the rate and terms of their APR, including whether it’s fixed or variable. It enables the borrower to establish a budget, use their loan wisely, and make consistent payments toward both the principal loan balance and the interest for the privilege of borrowing money. Inconsistent or failed payments can make a significant difference in the total amount of interest paid over the life of the loan.

 

Related Reading

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Effective Annual Interest Rate Calculator
  • FICO Score
  • Prepayment
  • Simple Interest

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