Whether you need some extra funding for home repairs, debt consolidation, a cross-country move or another expense, getting a personal loan can help you obtain the cash you need to cover a wide variety of purchases. Taking out a loan is often an ideal way to finance something you’d have trouble paying for upfront, but it’s also a big step that can impact your financial situation in a number of ways. It’s essential to understand the effects a personal loan can have, and one of the best ways to do so is to understand key details of the loan itself.
The annual percentage rate (APR) is one of these key loan features you’ll want to know more about before you sign on the dotted line. It can also serve as a great tool that helps you comparison shop for the most affordable loan terms. Before you head to the bank, learn more about what APRs are, the average APRs you can expect to encounter when looking at loans and the ways these rates are calculated.
Understanding APRs for Personal Loans
An APR is the amount of interest you can expect to pay on your personal loan over the course of one year, plus any fees or charges you may incur for the loan. This percentage rate is based on the daily periodic rate, which is the rate at which interest compounds, or is added to the loan. Some personal loans are compounded daily and others are compounded monthly, meaning the interest is added to the loan every day or every month, respectively.
For a personal loan, an APR is typically a much more consistent, predictable number than in other lending arrangements with interest rates that tend to fluctuate more, such as credit cards. Some personal loans have a fixed APR, meaning the APR remains the same for the life of the loan. Others have a variable APR, and this type of APR changes periodically based on the rates released by a specified financial index. The APR comes from adding the total interest on the loan to any fees associated with the personal loan. Then, that total is expressed as an annual percentage. For example, having a 20% APR on your loan means you can expect to pay roughly 20% of the principal amount each year in interest and other fees.
The average APR for personal loans is just over 9%, according to the Federal Reserve, but some loans might have 0% APRs and others may have APRs of 25% or more. APRs became more prominent when the Truth in Lending Act of 1968 ordered loan companies to clearly disclose the rate to borrowers. An APR gives you a more accurate estimate of all the interest and fees you can expect to pay back than the interest rate alone does.
How Are APRs Calculated?
Although a bank will inform you of the APR for a personal loan when you’re researching your options, it can be helpful to understand the numbers that go into the equation. Although there are several ways to calculate APRs, the process below is one of the most common:
- First, add up the total fees for the loan plus the interest you’ll pay over the life of the loan.
- Divide this number by the total number of days in the loan term (for example, a five-year loan term would be 1,826 to account for a leap day).
- Multiply that rate by 365.
- Take that amount and multiply it by 100 to convert it to a percentage.
The Difference Between APRs and Interest Rates
APRs and interest rates are easy to confuse. Both are expressed as percentages of the total loan amount. The interest rate is the percentage that the lender charges you for taking out a personal loan. The APR expresses the percentage of interest and fees that you’ll pay on the loan each year. The interest rate is a component of APR. With personal loans, APR is usually advertised instead of the interest rate.
Consider this example. John takes out a $5,000 personal loan with a 10% interest rate and a $700 loan origination fee. The loan term is one year. To figure out John’s APR, first we divide his total fees plus interest over the life of the loan by the loan’s principal amount.
- The total interest is $5,000 x 10%, or $500.
- The only fee is the loan origination fee of $700.
- The total fees plus interest over the life of the loan = $1,200, or $500 + $700
Next, we divide that $1,200 by the principal loan amount of $5,000 to get 0.24. This is the daily periodic rate.
Next, we divide the daily periodic rate by the number of days in the loan term. Because this is a one-year loan, the term has 365 days:
- 0.24 / 365 = 0.00006575
Because this loan term is only one year, we multiply by 365 to find the annual rate. In this case, the equation leads back to 0.24. To get the final percentage, we multiply by 100:
- 100 x 0.24 = 24, or 24%
John’s interest rate is 10%, and his APR is 24%. The APR shows the total interest and fees John will pay in a year, but the interest rate only shows a portion of the cost of the loan he’ll pay.
What Determines APR on a Personal Loan?
APRs aren’t set in stone for every applicant, and most lenders advertise APRs as wide ranges. For example, an APR range on a personal loan might look like 5.99%-29.99%. There’s typically a large variation because the APR an applicant is eligible for depends on their individual credit profile.
Because applicants often don’t have to put up collateral to back personal loans, lenders offer drastically different APRs depending on a borrower’s creditworthiness — a measure of how likely they are to repay debts. A person who might be denied another type of loan because they have poor credit — and thus have a higher risk of not repaying the loan — may be approved for a personal loan, but they’ll likely have a much higher APR than a borrower who’s more creditworthy.
An APR is directly influenced by factors pertaining to both the borrower and the loan. Lenders use a borrower’s debt-to-income ratio, credit score and monthly income to determine what APR the person qualifies for. In relation to the loan, the interest rate, loan term and origination fee also have a significant bearing on APR. Higher fees and interest rates directly correlate with a higher APR.
Even if you’re approved for a personal loan, you might not want to pay the APR you’re offered. You do still have some room for negotiation. Most lenders give borrowers options as far as loan terms go. If you opt for a higher monthly payment amount and shorter loan term, you’ll likely receive a lower APR than you would if you went with a longer loan term and smaller monthly payments. Shopping around for personal loans with multiple lenders can also help ensure you’re getting the APR you prefer.
Borrowers with low debt-to-income ratios and high credit scores are considered less risky to lend to, and lenders are more apt to negotiate with them. If you’re able to defer applying for a personal loan, it can be helpful to work on improving your credit score before you do apply. This can help you obtain a lower APR and a variety of other benefits that come along with good credit.
