Annual percentage rates come into play when borrowers look to obtain mortgage loans or credit cards. The annual percentage rate, or APR, is the amount of interest you'll pay on your loan annually, averaged over the entire term of the loan. The lower your APR, the lower your payments will be on the loan you take out.
Annual percentage rate versus interest rate
The interest rate on a loan represents the cost of borrowing whatever the principal amount happens to be. Interest rates are always expressed as a percentage and calculate what the actual monthly payment on your loan will be.
The annual percentage rate, by contrast, offers a more complete picture as to how much you'll pay to borrow the principal amount in question, as it reflects the total costs of the loan. The APR is also expressed as a percentage. Lenders are required to disclose their APRs to borrowers, which is why you'll typically see this information on mortgage documents or credit card agreements.
APR vs. APY
When you borrow money, the total amount of interest you actually wind up paying depends on how often that interest is compounded. Compounding is a way of adding interest to a loan's principal so that more interest can be charged. As an investor, compounded interest is a good thing because it allows you to make more money. As a borrower, however, compounded interest is a bad thing because it increases the amount you ultimately pay to borrow money. Generally speaking, the more compounding periods a loan has, the more interest you'll wind up paying.
While the APR represents the annual rate of interest without taking compounding into the equation, the annual percentage yield, or APY, does take compounding into consideration. APY is a representation of an interest rate based on a one-year compounding period. The APR, by contrast, is a simpler form of calculating interest, as it is arrived at by multiplying the periodic rate of interest by the number of periods in the year. The greater the difference between APR and APY, the more frequently interest is compounded.
Here's how the concepts relate in practice: If you carry a balance on your credit card, you'll end up paying an APY that's higher than your card's quoted APR. The reason is that interest charges are added to your outstanding balance month after month, which means that for every month you carry a balance, you'll have to pay interest on those interest charges in addition to interest on your principal.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!