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How Does APR Work?

If you have ever taken out a loan for a mortgage, automobile, education, or some personal reason, then you should know what an annual percentage rate (APR) is. At any rate, most people understand that it is some sort of charge on top of the loan. Despite that general concept, a ton of people don’t really understand how it works, and less than enough people seriously take APR into consideration before signing up for a loan. With that said, I am going to cover one of the most basic considerations that need to be made when you are shopping for different APRs on any sort of loan you may or may not take out. I’ll cover some basics by jumping right into it!

What is APR?

As mentioned earlier, APR stands for annual percentage rate. If it sounds completely foreign to you, then just think of it as an interest rate for now even though it is technically different. APR is how the banks and lenders make money! They offer a loan to a consumer and they tack on this APR. Each month, that APR defines how much you will owe in interest on top of the principal balance. For those who do not know, a low APR is preferable to a high APR. Higher APRs mean you’ll end up paying more in interest over the life of your loan.

How Does It Work?

Well, here is a quick run around on how APR works. The annual part means it is calculated over the year despite being applied every month. This is where many people (at least some of the people I’ve talked to) get confused. If you have a 12 percent APR, you will be charged 1 percent interest each month; at the end of the year, that amounts to your 12 percent APR. You will NOT be charged 12 percent each month! It isn’t technically an interest rate because it is taken as a percentage over the year; it’s APR! Despite that distinction, these two terms are used interchangeably all the time. Just know that APR is divided up by twelve months out of the year, and each month you are charged that much in interest each month on your remaining principal balance on the loan.

Typical APRs to Expect

So APRs are defined by whoever is issuing the loan, credit card, or anything else involving interest. These companies rely on an underwriting system that is heavily dependent on credit score, or in other terms, they take into account your credit history when deciding how much money they want to try and charge you each month.

If you are considered a high-risk consumer, that means you do not have a good credit history (just a reminder, having a bad credit history means you’ve struggled to pay your debts on time in the past among other things of course). If you are a high-risk type of person who misses payments from time to time, then you are going to receive a higher APR. Think of it this way. You have a high APR, and you’re terrible at paying your bills on time. The lender is going to make a fortune off of you eventually. Despite that cynical thought, the high APR may actually be meant to discourage you from borrowing a loan in the first place! These last couple of ideas are just some of my ideas, but it remains true that those with unworthy credit generally receive higher APRs.

What is the Difference between a Variable and Fixed APR?

So let’s say you are in the market for a new loan. You need to figure out what annual percentage rate (APR) you want before signing the dotted line. By figuring out what APR you want, I mean you need to decide whether you want a variable rate or a fixed rate on your loan. They definitely aren’t the same thing! Despite being big and bad financial terms, it is easy to understand what they are and how they differ from each other.

APR Basics

So let’s cover a few basics about APR before moving forward. An APR is calculated over the entire year, but it is applied monthly. This means that if you had a 24 percent APR, then you are charged 2 percent each month. The APR defines how much interest you are going to owe from the last month, and that interest amount is tacked on to your principal balance. Well, there is a small lesson in interest payments right there. It wasn’t all inclusive, but it works for this article.

What is a Variable APR?

So here is a quick spoiler: variable APRs change or vary with time. How do they change exactly? Well, they are dependent of the fluctuation of the market. So look at it this way with my quick, cheap example. One year you get a loan with a variable APR of 2 percent because interest rates are low in the market overall. After five years with the loan, you notice that your APR has now doubled to 4 percent. This is because you picked the variable rate, and it is subject to change depending on the market. That scenario sounds awful, but it’s a two-way street, meaning your interest rate could decrease over the same time period. Think of it as a gamble of sorts.

I keep mentioning the market, but I haven’t explained it yet. There is this rate that all of the big banks and groups lend to each other in the stock market. It may differ in name from market to market, but generally, there is a base rate that the big dogs base their rates on. In the United States, the Federal Reserve sets this base rate. All of the lenders tack on basis points (another term for percentage basically) to this rate. There you have it.

What is a Fixed APR?

A fixed APR is a much simpler horse to handle. Like a variable rate, a fixed rate is determined by the market at the start of the loan, but instead of changing over time, it remains fixed at that rate upon disbursal of the loan. It offers more certainty than a variable rate loan because there is no risk of your rate increasing later on, but there is less potential to save on interest down the road.

What’s the Difference?

One of them changes and one of them doesn’t! A fixed rate offers more certainty by keeping the rate stable, but it leaves out the potential for a reduced rate later. A variable rate offers the potential for a lower rate later on, but it’s also much riskier than a fixed rate.

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