What is APR? Understanding annual percentage rate

^{Links to external websites are not managed by Varo Bank, N.A. Member FDIC. All Varo products and services mentioned below are contingent on opening a Varo Bank Account. Qualifications may apply.}

When shopping for a credit card or loan, you may encounter the term "APR." But what does it mean, and why should you care? 

APR is short for Annual Percentage Rate, and if you're one of the 49% of cardholders who carry a credit card balance month-to-month, it can be a critical element of credit to understand— especially since interest rates have continued to rise, reaching an average of 22.75% in the first quarter of 2024.

Let’s go over everything about an Annual Percentage Rate (APR), how it differs from a traditional interest rate, and why it can be important to pay attention to APR when trying to save money over time. This article can help educate those applying for a credit card, line of credit, or personal loan.

What is APR (Annual Percentage Rate)?

Annual Percentage Rate (APR) measures the total cost associated with borrowing money over the course of a year. It's a percentage, like you’d see on an interest rate, but takes other costs into consideration as well.

When you borrow money through a credit card, personal loan, or mortgage, you don't just pay back the amount you borrowed (also known as the principal). You typically also pay interest, which is essentially the additional cost of borrowing that money. But here's the kicker— there can also be other fees to be aware ofm, like origination fees, annual fees, discount points, or closing costs.

APR combines the interest rate with all other applicable fees (not including the principal)— rolling them into one tidy percentage. So, when you see an APR, you're looking at the total yearly cost of that specific loan or credit card.

For example, if you're considering a personal loan for $1,000, with an 8% interest rate and a $20 origination fee (2% of the total loan), then the APR would be 10% because it includes both the interest rate and the origination fee. 

This simplified version of the formula illustrates that APR includes all the fees associated with the loan, but there may be many factors that can contribute to this percentage, including length of the loan, compounding periods, and more. 

How is APR Calculated?

Now that we know what Annual Percentage Rate (APR) is, you might wonder how lenders calculate it. APR is not decided on a whim, there's a specific formula involved. 

In a typical annual APR situation, the formula can look something like this:

APR = (((Interest + Fees) / Principal / n) x 365) x 100

Let's break that down:

• Interest is the total amount of interest you'll pay over the life of the loan

• Fees include any additional charges, like origination fees or closing costs

• Principal is the total amount you're borrowing before interest/fees

• n is the number of days in a year, which is typically 365

Example scenario

Let’s say you need a small loan of $1,000 and are attracted by the 5% interest rate. However, you haven’t considered the administration fees, which could go by many names. Calculating the APR would show you that the effective interest rate is actually much higher than the stated rate of 5%. 

For a $1,000 loan with a 1-year term, 5% interest rate ($50 in interest), and $150 in origination fees, the APR calculation would look something like this:

((($50 + $150) / $1,000 / 365) x 365) x 100 = 20% APR

A 20% APR is much higher than the 5% interest rate advertised. 

Fees to consider

Lenders can include different fees in their APR calculations, so it can be valuable to read the fine print listed in the Terms and ask questions. Some common fees to watch out for include:

• Application fees

• Origination fees

• Closing costs

• Annual fees (for credit cards)

• Mortgage Insurance

Mortgage insurance fees, for example, may fluctuate between 0.30% and 1.20% on top of the loan amount per year.

APR vs. Interest Rate: What's the Difference?

To reiterate, while Annual Percentage Rate (APR) and interest rates are closely related, they are not the same thing.

An interest rate is the cost of borrowing the principal loan amount. It's the percentage of the loan you'll pay back in addition to the amount you borrowed. For example, if you take out a $1,000 loan with a 5% interest rate, you'll owe $1,050 in total—the original $1,000 principal plus $50 in interest.

On the other hand, APR usually includes the interest rate, any fees (like those listed above), and other charges associated with the loan. So, if that same $1,000 loan also had a $50 origination fee, the APR would be higher than 5% because it would factor in both the interest and the fee.

A side-by-side comparison

Loan A

5% interest rate on $1,000, no additional fees:

• Interest rate: 5%

• APR: 5%

Loan B

5% interest rate on $1,000, $50 origination fee:

• Interest rate: 5%

• APR: 10% (assuming a one-year loan term)

As you can see, Loan A and Loan B have the same interest rate, but Loan B has a higher APR due to the origination fee. If you were comparing only interest rates, these loans seem identical, but the APR reveals that Loan B is more expensive.

Types of APR

Not all Annual Percentage Rates are created equal. When shopping for credit offers, you may encounter these different APR types.

Fixed APR

This type of APR stays the same throughout the life of the loan, which means your monthly payments will be predictable and consistent. It can be a good choice if you prefer stability and want to avoid surprises down the road.

Variable APR 

A variable APR can fluctuate over time based on market conditions. It's often tied to an index rate, like the Prime Rate, so your APR will follow suit when that rate goes up or down. 

Introductory or Promotional APR

Lenders sometimes offer a low, introductory, or even 0%, APR as a limited-time promotion— often to entice new customers. These might be a great deal only if you can pay off your balance before the promotion ends and the rate increases.

Penalty APR

If payments are missed or other agreement terms are violated, lenders might tack on a penalty APR. These penalty rates could be sky-high, often up to 29.99%. 

Cash Advance APR

Many times, if credit cards are used to withdraw cash from an ATM, there might also be a separate APR charge for that transaction in addition to out of network fees. Many cash advances like this start accruing interest immediately often with no grace period. 

Factors that Affect Your APR

Now that you're an expert on the different types of APR, let's talk about the factors that can influence the rates that may be offered.

Credit Report and History 

Credit reports are like a financial report card. Generally, the higher your rating on your credit report, the lower your APR can be. If your credit is a bit banged up, don't despair—you can help build your credit up over time by paying bills on time, keeping balances low, and avoiding new credit applications.

Loan Type and Term

The kind of loan you're seeking and how long it will take to pay back can also impact your APR. For example, a 30-year mortgage will typically have a higher APR than a 15-year mortgage because the lender is taking on more risk by lending money for longer.

Lender and Market Conditions 

APRs typically vary from lender to lender, so it may be wise to shop around and compare offers. Additionally, market conditions like the overall economy and benchmark interest rates can influence lenders' APRs at any given time.

Limitations of APR

While APR is undoubtedly useful for comparing the cost of borrowing money from different creditors, it's not perfect. Here are a few limitations to keep in mind:

• APR doesn't account for compound interest, which is the additional interest you pay on starting interest over time. 

• APR may not reflect the true cost of a loan if you pay it off early. Some loans can come with prepayment penalties which add to the total cost.

• Lenders can calculate APR differently by including or excluding certain fees, so it's not always an apples-to-apples comparison. 

Note: APR and APY (Annual Percentage Yield) are two different things. While APR applies to borrowing products like lines of credit and credit cards, APY is instead the rate money is earned on money in your savings. When comparing savings accounts, look for a high APY savings account to maximize your earnings.

Remember, understanding APR is just one piece of the puzzle— keep in mind the importance of borrowing responsibly, living within your means, and prioritizing saving to reach your goals.

Now, let's talk about lines of credit. 

Exploring a Straightforward Line of Credit

A line of credit is a flexible borrowing option that allows access to funds up to a pre-approved limit. You typically only pay interest on the amount you borrow.

Varo Line of Credit¹ is unique, as it’s designed to help our customers cover unexpected expenses or bridge short-term cash flow gaps without interest.

• Once qualified, borrow up to $2,000

• Pay a flat, fixed fee (no interest)

• Fixed monthly payments over the course of 3 to 12 months (depending on the amount borrowed)

• No origination fees, late fees, penalties, or prepayment penalties

And as with all of our products, Varo never tacks on additional fees. 

Get started with Varo today or click to learn more about Varo Line of Credit!

^{1 The Varo Line of Credit is designed to help customers with unforeseen expenses with monthly payments, no late fee, no prepayment penalties, and no interest. To be eligible, your accounts must maintain a positive balance. Minimum monthly deposits, average daily balances, and other eligibility requirements apply. Once qualified for Varo Line of Credit, you will be assigned a credit limit from $600 to $2,000. A one-time fee is added to your borrowed amount, early repayment of your advance does not reduce the one-time fee. Your credit limit may fluctuate from one advance to the next based upon a variety of factors. You may only take one Varo Line of Credit out at a time. Your eligibility information and/or credit limit is always available to you in the home screen of your Varo app. Checking offer eligibility will not impact your credit score. If you are eligible and choose to apply for an offer, we will pull your credit and your credit score may be impacted.}