Understanding Variable APR
Whether you need extra money to pay an emergency expense, expand your business, or to use as working capital, it’s not uncommon to seek financing in the form of a loan, line of credit, or credit card. Before signing a contract with a lender, though, it’s important to fully understand the cost of your loan.
While shopping around for financing, you’ll likely find financial products that feature a variable APR. If you’re scratching your head in confusion, this post is for you. Before entering into a loan agreement, read on to learn more about variable APR, how it’s different from fixed APR, and the benefits and drawbacks to consider.
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What Is APR?
Before we jump into the specifics of variable APR, what is APR in general?
APR is the annual percentage rate of your loan, credit card, or other financial product. In simpler terms, APR is the total cost of borrowing for a period of one year. The APR includes the interest you pay to the lender as well as any additional fees, such as origination fees or packaging fees.
As you’re shopping for a loan, it’s vital to look at the APR in order to find the most affordable financing option. Let’s say you’re considering one loan that has a low interest rate but comes with additional fees. Another loan option has a slightly higher interest rate but no fees are charged. In this example, the APR for the first loan — the one with the lower interest rate — may actually be higher than the APR for the second loan. Even though the first loan has a lower interest rate, the added fees give it a higher APR — which means a higher overall cost.
If this scenario is confusing, don’t worry. Most lenders perform APR calculations for you before you sign your loan agreement. If they don’t, or you want to see the numbers for yourself, check out our calculators for term loans, short-term loans, and merchant cash advances.
One thing to remember is that APR doesn’t always tell the full story surrounding the cost of your loan, particularly if you’re dealing with a non-traditional loan product, like a merchant cash advance or a short-term loan. Term lengths may also be a factor in determining the overall cost of borrowing. Refinancing or prepaying your loan can also have an impact on what you pay each year. Still have questions about APR? Learn more about the basics before applying for financing.
What Is Variable APR?
By now, you should have an understanding of APR at the most basic level and how it affects the cost of borrowing. Maybe you’ve even started shopping around for financing. But in your quest to find a loan, you may be faced with a new term: variable APR.
If your loan or credit card has a variable APR, it means that the interest rate will fluctuate over time. These fluctuations are based on an interest rate index that serves as a benchmark for the interest rates charged by lenders. Many lenders use the Wall Street Journal Prime Rate, which uses the base rates on corporate loans posted by at least 70% of the nation’s top 10 banks.
Interest rates are always based on the prime rate, but the number of percentage points a lender adds is based on the risk of the borrower. Low-risk borrowers, such as established businesses with high revenue and solid credit histories, will have a lower number of percentage points added to the prime rate. A higher number of percentage points will be added to borrowers with low credit scores or revenues or a short time in business, making the overall cost of the loan higher over time for riskier borrowers.
With variable APR, both low- and high-risk borrowers may see fluctuations in their APRs based on changes to the interest rate index. When the prime rate increases, so does the APR. When the prime rate drops, the APR is lower.
Variable APR VS Fixed APR
Loans, credit cards, and lines of credit come with either variable or fixed APR. Unlike products with variable APRs, financing options with fixed-rate APRs never change. This means that if your APR is 5%, it is 5% for the life of the loan; the rate will not change if the prime rate increases or decreases. However, there are some instances where an APR can change even on a fixed-rate product.
If the APR on fixed-rate financing alters from its original terms, the lender must notify the borrower in writing. Most lenders provide a grace period that allows the borrower to pay off the debt and close the account or transfer the balance before the new terms are applied.
With a variable APR, the lender does not have to notify the borrower of changes to APR based on changes to the prime rate.
Is A Variable APR Good Or Bad?
A variable APR can be good for short-term use. For example, if you use your credit card and pay it off each month, you’ll save money when rates are low.
However, if you plan to use your financing over the long term, there is a risk that rates could rise. This could result in a higher cost of borrowing.
This doesn’t mean that if you need a long-term financing option, you should write off variable APRs. Long-term loans like Small Business Administration 7(a) loans have variable interest rates. Interest rates are based on the prime rate plus a markup between 2.25% and 4.75%. SBA loans are some of the most competitively-priced and affordable long-term loan options for small business owners.
When applying for a credit card, one thing to be aware of is that many card issuers offer introductory rates. These introductory rates are fixed and are lower than usual for a set period of time, such as 6 or 12 months. After the introductory period, the interest rate increases. A fixed rate may also revert to a variable rate after the introductory period. This is why it’s so important to carefully read all disclosures and agreements before opening an account.
Looking for a business credit card? Compare rates side-by-side to find the best option for your business.
Final Thoughts
APR is incredibly important to consider before applying for financing, but you need to consider all other factors before choosing your lender. The goal of your financing is to get rates and terms that work for you and your business. Shop around, do your research, and read everything before signing on the dotted line to find financing that best fits your financial needs.