Annual Percentage Rate
Annual percentage rate (APR) refers to the yearly interest generated by a sum that's charged to borrowers or paid to investors. APR is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan or income earned on an investment. This includes any fees or additional costs associated with the transaction but does not take compounding into account. The APR provides consumers with a bottom-line number they can compare among lenders, credit cards, or investment products.
Definition: The Annual Percentage Rate (APR) is the annual interest rate that a borrower must pay or an investor can earn. Expressed as a percentage, APR represents the actual annual cost of funds over the term of a loan or the income from an investment. It includes any fees or additional costs associated with the transaction but does not take compounding into account. APR provides consumers with a baseline number to compare different lending institutions, credit cards, or investment products.
Origin: The concept of APR originated in the early 20th century as financial markets developed and consumer protection awareness increased. In 1974, the United States passed the Truth in Lending Act, requiring financial institutions to clearly disclose APR, allowing consumers to compare different financial products more transparently.
Categories and Characteristics: APR can be categorized into fixed APR and variable APR.
- Fixed APR: Remains constant throughout the loan or investment period, suitable for consumers who prefer stable repayments or returns. The advantage is rate stability, while the disadvantage is the inability to benefit from lower rates if market rates decrease.
- Variable APR: Adjusts according to market rate changes, suitable for consumers willing to take some risk in hopes of obtaining lower rates. The advantage is the potential benefit from decreasing market rates, while the disadvantage is rate instability, which may increase repayment pressure.
Examples:
- Example 1: John applies for a fixed-rate mortgage with an APR of 5%, a loan amount of $100,000, and a term of 30 years. John needs to pay $5,000 in interest annually, with the rate remaining constant throughout the loan period.
- Example 2: Jane chooses a credit card with an APR of 18%. She spends $1,000 in one month. If she does not pay off the balance in full the next month, she will be charged interest at an 18% annual rate, approximately $15 per month.
Common Questions:
- Question 1: What is the difference between APR and APY?
Answer: APR does not consider compounding, while APY does, so APY is usually higher than APR. - Question 2: Why do different loan products have significantly different APRs?
Answer: The differences in APRs among loan products are mainly due to variations in loan amounts, terms, credit scores, and market rates.
