Annual Percentage Rate (APR): What is it and how does it work?
APR or Annual Percentage Rate is a term you may have definitely come across while looking to further your knowledge of investment terms. Simply put, it's a number that tells you the cost you'll incur — over one year’s time — when you borrow money. So naturally, you want this to be as low as possible. APR takes into account the interest rate plus other fees and costs, but does not incorporate compounded interest. Let’s take a closer look.
What does APR stand for?
APR stands for annual percentage rate. It's a way of thinking about how much you pay in interest to the lender over time, taking into account the stated interest rate and other things like fees and penalties.
A credit card's APR is the rate at which you will pay interest over time on your balance if you don't make your payments on time or carry a balance from month to month. It's important to note that in addition to APR, other fees determine your total cost of borrowing money such as annual or origination fees.
How does APR affect my financial decisions?
When you are considering borrowing money, adding up all the costs associated with it (like origination fees and late fees) can help you decide if it's worth going through with in the first place.
Once you've done that, compare those costs against how much interest you pay over time. People who have a goal of financial freedom should definitely know how APR impacts their financial decisions.
Furthermore, people concerned with managing their finances wisely should be aware of the role APR plays in determining cost over time, allowing them to make decisions based on an accurate assessment of total expenditures.
How to calculate APR?
APR calculation includes fees and other charges in addition to the stated interest rate, so it's essential to check the fees and whether they change over time (for example, check if there's an annual fee).
APR is calculated by adding up all of your payments over one year and dividing that by 12 months. You can calculate APR by taking all of your charges, adding them up, and then dividing that number by the amount of time you have to repay this loan.
For example, if a credit card is offered at an APR of 10%, you will potentially be paying about €100 per year for every thousand dollars that are borrowed. The loan or credit card with the lowest APR is typically the least expensive.
How does APR work?
APR is calculated by taking into account monthly payments and other factors that affect the total cost of a loan, then expressing them as a percentage of the original amount borrowed.
The annual interest rate earned on investments is called the nominal interest rate. However, it does not account for additional money that can be made by reinvesting interest payments.
An APR is a more accurate way to compare interest rates on different loans. As a result, it's helpful when comparing the costs of credit cards, mortgages, and other types of debt.
What is a variable APR?
Variable APR reflects the cost of borrowing money over time. It uses a formula that considers your interest rate and the length of time you're planning to borrow money.
The APR for variable loans is typically higher than fixed-rate loans because the lender isn't sure exactly how much you'll owe in interest over time. The longer you have a variable APR loan, the more likely that your monthly payments will increase.
If there's an economic downturn and interest rates rise, this could cause a spike in your monthly payment.
What is a fixed APR?
When comparing different loans, it is difficult to determine which form of loan offers the best terms; however, this depends on your situation. Fixed APR does not change its value, so it will stay the same no matter how long you borrow the money.
For example, if you borrow €1000 for one month and pay off €10 in interest, your variable APR will be 1%. But if you borrow €1000 for one month and pay off €100 in interest, your variable APR will be 10%.
Fixed APR vs. Variable APR
When making financial decisions, it's important to distinguish between fixed and variable interest rates. If you misunderstand the difference, you could end up paying more than necessary.
The temptation to borrow a lower fixed rate from the lender is strong, but this could be a mistake. The reason is that your variable APR will likely change as interest rates fluctuate over time.
Variable APR is better for short-term loans. Short-term loans are more expensive than long-term ones because a lender can't predict what future rates will be.
For instance, if you have a fixed APR of 10% and interest rates go up by 2%, your loan payment will increase accordingly.
APR in Crypto
Even in the world of crypto APR is a term that is often used on centralised exchanges or DeFi protocols. It is used in a similar context like that of a bank loan - for a variety of lending and borrowing opportunities, staking or liquidity pool services.
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This blog is for educational purposes only. The information we offer does not constitute investment advice. Please always do your own research before investing.
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