What Is APR?
When you borrow money you will often see the term APR, and you might not be quite sure what it means. APR helps you understand the cost of a loan, but it can be misleading. Sometimes fees are included, and sometimes the loan with the lowest APR isn’t always the best choice.
What Does APR Mean?
APR stands for Annual Percentage Rate. It tells you how much it costs to borrow for one year, including interest costs and additional fees related to a loan. APR is the “price” of a loan quoted in terms of an interest rate.
Once you know how much it costs to borrow, you can compare loans and credit cards by comparing the APR.
In it’s simplest form if you borrow £100 at 10% APR. Over the course of one year, you will pay £10 in interest because £10 is 10% of £100. To calculate, multiply £100 by 0.10 to arrive at £10 (£100 x 0.10 = £10). Note that the percentage is converted into a decimal format in order to do the calculation
In reality, you’ll probably pay more than £10. The example above assumes interest is calculated and charged only once per year and you don’t pay any fees, which in most cases probably won’t be accurate. APR is an annualized rate. In other words, it describes how much interest you’ll pay if you borrow for one full year.
In most cases you can usually assume that a lower APR is better than a higher APR (with mortgages being an important exception).
What Is 0% APR?
If you’ve seen advertisements offering “teaser” deals, you’ll probably be wondering what 0% APR means. 0% APR suggests that no interest will be charged on money you borrow. Borrowing for free might sound great, but it rarely lasts long. These 0% APR offers are designed to get you in the door so that lenders can eventually charge you interest. It’s good to remember that 0% APR offers can help you save money on interest, but there will be other fees to borrow added onto your loan.
It is possible to pay absolutely nothing and take full advantage of a 0%APR offer, but you have to be diligent for this to work in your favour. It’s essential to pay off 100% of your loan balance before the promotional period ends and to make all of your payments on time. Failure to do so can mean you end up paying high interest charges on any remaining balance.
What Does Variable APR Mean?
If an APR is variable, then it can vary or change over time. With some loans, you know exactly how much you’ll pay in interest as you know how much you’ll borrow, how long you’ll take to pay it back, and what interest rate is used for interest charges. Loans with a variable APR are different. The interest rate might be higher or lower in the future than it is today (lower would be better, but higher is more likely).
Variable-rate loans are risky because you might think you can afford to borrow given today’s rate, but you may end up paying a lot more than you expected. On the other hand, you’ll typically get a lower initial interest rate if you’re willing to assume the risks of using a variable APR.
What might make your interest rate increase?
Variable APRs typically rise when interest rates in general rise. In other words, they rise in sympathy with interest rates on savings accounts and other types of loans. But your interest rate can also increase as part of a “penalty” (whether you have a variable APR or not). If you fail to make payments or hit a universal default trigger, your rates can jump dramatically. You might not have to pay higher rates on your existing loan balance, but you’ll lose the ability to borrow at the lower rate in the future.
What Affects APR?
Whether you pay a high APR or a low APR depends on several factors:
- Type of loan: some loans are more expensive than others. Home loans and car loans generally come with lower rates because the home is available as collateral and people tend to prioritize those loans. Credit cards, on the other hand, are unsecured loans so you have to pay more as a result of the increased risk.
- Credit: your borrowing history is an important part of any lending decision. If you can show a solid history of repaying loans on time (and therefore you have great credit scores), you’ll get lower APRs on almost every type of loan.
- Ratios: again, it’s all about the risk. If lenders think they can avoid losing money, they’ll offer lower APRs. For home and car loans, it’s important to have a low loan to value ratio (LTV) and good debt to income ratios. Good ratios show that you’re not biting off more than you can chew, and that the lender can sell collateral and walk away in decent shape if necessary.