As a small business owner, it’s imperative that you understand financial terms so that you can make smart and informed decisions when borrowing money. APR, or annual percentage rate, is one of those terms you need to get to grips with if you intend on taking out a loan. In this post we’ll answer the question “what is APR?” and discuss APR meaning in practice.
What is APR (annual percentage rate)?
Annual percentage rate (APR) refers to the annual interest charged on a loan or earned by an investment. Simply put, APR represents the price you pay to borrow money. You can use APR figures to compare lenders, credit cards and investment opportunities. Then, you can choose the best lending option for you.
However, bear in mind that an APR is more of an estimate than a precise figure, as lenders have a certain degree of leeway when calculating it. Plus, it can sometimes exclude extra fees.
In order to determine how much interest you pay on an outstanding balance, banks use an APR calculator, or calculation formula. This can be calculated daily or monthly.
APR is calculated by multiplying the periodic (daily, monthly) interest rate by the number of periods it will be applied annually.
Be aware that some accounts have multiple APRs, and that the various costs included in an APR calculation can vary. An APR for a mortgage, for example, can include origination fees and other costs.
Types of APRs
There are several types of APRs, but the principal types are fixed APR and variable APR.
Getting to grips with the different types of APRs can help in choosing the right loan for you.
Bear in mind that APR will also vary according to the type of credit you’re seeking. A credit card’s APR, for instance, is usually far higher than that of a property loan.
Below are some of the types of APRs you need to know about.
A fixed APR typically doesn’t change for the duration of your loan. The advantage of this is that you can financially plan and budget easily as you know precisely how much you will be paying at each interval.
Variable APR changes according to an index interest rate, such as the prime rate. As the prime rate increases/decreases, so does your variable APR. This means what might start out with a low APR which becomes more and more expensive over time. This makes it a bit of a risky venture, and ultimately more difficult to budget and plan your finances.
If you fail to meet the terms of your loan contract, for example by making late payments or failing to pay at all, then the APR on your card may increase for a period. Make sure you check the terms of your loan so that you know exactly what to expect if you violate them.
When you receive a new credit card, it may come with a temporarily lower APR. This is known as introductory APR.
What can influence APR?
An APR is dependent on several factors. Your credit history, credit score and previous credit activity can have an affect on your proposed APR. Plus, as already mentioned, late payments can also cause an APR to increase on an existing balance.
What’s the difference between annual percentage rate (APR) and effective annual rate (EAR)?
Annual percentage rate and effective annual rate are often lumped into the same category. However, they do have key differences.
The essential difference between APR and EAR is that APR is based entirely on simple interest, whereas EAR also incorporates compound interest, which is basically the interest you earn on interest.
APR is typically the best option for determining mortgage and car loans, whereas EAR is more useful for determining compounding loans such as credit cards.
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