What Is an Annual Percentage Rate?

September 13, 2019 | Mission Fed

Man holding the keys to his new SUV.

The two terms that are often used interchangeably when talking about loans are: interest rates and annual percentage rates (APR). Interest is the percentage you pay each month based on the total amount borrowed (otherwise known as the “principal”). APR gives you the cost of the loan each year as a percentage by taking into account interest rates and fees.

These rates are decided by the type of loan and by various factors like your credit score. Knowing what an APR is, how it can affect your ability to take out loans, and how to find the best APR are three factors worth considering if you are taking money out for a home or car. Check out our credit union rates.

Why APR is Important

An easier definition of an APR is thinking of it as the price you pay to borrow money. People need to borrow money for numerous reasons, and an APR will apply when you:

  • Buy a car
  • Apply for a credit card
  • Finance a home
  • Start a small business
  • Get student loans

The rate will determine how much each of these financial investments cost over the lifetime of the loan.

Fixed vs Variable APR

The two main types of APR on a loan include fixed APR and variable rate APR. A fixed APR is predictable and will not alter through the course of the loan term. This could be beneficial if a downturn in the economy causes interest rates to spike.

Variable rate APR is based on the interest rate index, which is posted in the Wall Street Journal. The interest rate index determines what a lender can charge on a mortgage loan. If you believe the economy will improve over time and that rates will decrease, a variable APR could be more beneficial.

What are Typical APRs?

Whether you are buying a house, applying for college, or thinking of a new car, their respective loans will come with different annual percentage rates. A car costs one-tenth of a home and its loan term could be relatively short—less than two years. For this reason, a car loan APR is generally higher than, say, a 30-year home loan.

When going through typical APRs, keep in mind there are many factors that determine what APR you receive for your loan.

Car Loans

Receiving the lowest APR for your car loan depends on a few factors: the loan term, your credit score, and who is offering the loan. Cars are depreciating assets whose values decrease by about 10% to 15% each year for the first four years. If you don’t have a down payment or low APR, your car could quickly turn upside-down—when the value of the car is less than the money owed. At that point, selling your car would be a net loss.

To avoid this, here’s what you need to know about car loan APRs:

  • Credit score – Start with the most substantial factor: your credit score. Credit unions, banks, and dealerships will rank people into four FICO score categories: poor credit (less than 630), average (630-690), good (690-720), and excellent (more than 720). Depending on which category you fall under, you can expect to pay a few percentage points higher or lower. Here is how the same two-year loan could look based on credit scores:
    • 10% or higher APR for poor credit scores
    • 7-10% APR for average credit scores
    • 4-7% APR for good credit scores
    • 3-5% APR for excellent credit scores
  • Car loan terms – Say you want a 2016 Honda at about $25,000. You have a good credit score and receive a 36-month loan. This will put you in the ballpark of $750 as a monthly payment. This same situation with a 72-month loan could be a $400 monthly payment. How enticing! You are paying $350 less each month. But this is where the trick comes in. The total payment on the car would be $27,000 for the first scenario and $28,800 for the second scenario. That’s an $1,800 increase on the principal amount. Be sure to use an online loan calculator to determine what’s best for your financial situation.
  • Who is offering the loan – Three institutions will gladly finance your car and knowing their motives might tell you who to trust with your finances.
    • Auto dealerships
    • Banks
    • Credit Unions

Credit Cards

Opening a line of credit on a credit card is a great opportunity to work on your credit score and to finance any immediate needs. Credit cards are great for:

  • Making large purchases
  • Disputing fraudulent charges
  • Financing projects
  • Building credit

Types of Credit Card APR

There are four common APRs that you might see in the terms and agreement.

  • Purchase APR – This is the rate you are billed for each credit card purchase.
  • Cash advance APR – Often higher than purchase APR, this is the cost of borrowing money from your bank or credit union.
  • Penalty APR – This deals with the credit card balance. If you owe money or are late in your payments, the penalty APR decides how much you are liable to pay in fees.
  • Introductory APRIntroductory APR – Most credit cards will start off with low introductory rates, but these promotions will only be available for a certain period. Be sure to know when it ends and what the new APR will be.

Home Loans

Buying a home is one of the biggest financial decisions people make in their lifetime. Loans will be in the range of hundreds of thousands of dollars, and upfront payments can be 10% to 20% of that. Mortgages are often paid over 15 to 30 years, making the interest rates and APR significant factors to how much your home costs.

When buying a home, here are some factors that affect APR:

  • Credit score – Much like for car loans, one of the most significant factors is your credit score. Having a poor credit score can increase your APR by a percentage point or more.
  • Down payment – The larger the down payment, the less you need to take out on loan. Plus, there are additional incentives that a financial institution will offer for higher down payments.
  • Loan term – Because of how interest accrues, the total interest paid on a home is roughly tripled when going from a 15 to a 30-year loan.
  • State you live in – Each state has its own average APR. Overall, most are between 3.5% to 4.5%.

You can use the government home loan calculator to determine how much extra you will pay on your home loan by inputting the above values for your specific home.

There are a few different factors for this decreased ownership. Student debt is at an all-time high, people are marrying later in life (which significantly increases household income), and Millennials are choosing to rent.

Business Loans

Small businesses come with high-risk loans. Half of all small businesses fail within five years of opening, and many of those don’t recover enough profits to fully pay back their initial investment.

APR in Summary

For someone who’s wondering, “What is an annual percentage rate?” the simplest answer is it is the total cost to borrow money. APR takes into account interest rates and other fees associated with the loan. These percentages will be tacked onto home loans, auto loans, credit cards, and any other type of lending.

To lower your APR and save on accrued interest, try to fix any financial troubles you have before asking for a loan. Increasing your credit score can save thousands on car payments and tens of thousands on mortgages.

The content provided consists of opinions and ideas and should be used for informational purposes only. Mission Federal Credit Union disclaims any liability for decisions you make based on the information provided. References to any specific commercial products, processes, or services, or the use of any trade, firm, or corporation name in this article does not constitute endorsement, control or warranty by Mission Federal Credit Union.

Sources

Consumer Financial Protection Bureau. Explore interest rates.
https://www.consumerfinance.gov/owning-a-home/explore-rates/

Urban Institute. Millennial Homeownership.
https://www.urban.org/research/publication/millennial-homeownership

Pew Research. Are young adult movers renting or buying?
https://www.pewresearch.org/fact-tank/2017/02/13/americans-are-moving-at-historically-low-rates-in-part-because-millennials-are-staying-put/ft_17-02-07_millennial-mobility_3/

Investopedia. Top 6 Reasons New Businesses Fail.
https://www.investopedia.com/slide-show/top-6-reasons-new-businesses-fail/

Mission Fed

Mission Fed

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