What is Annual Percentage Rate (APR)?

The Annual Percentage Rate, or APR, is the yearly amount that must be paid by a borrower in order to maintain and to pay off a loan. APRs are the commonly used terminology when discussing credit cards/lines of credit, auto loans/leases, and mortgages/real estate loans. 

While APR and the stated annual interest rate on a loan may sound like the same thing, they actually have key differences. The headline nominal interest rate shown on a loan is what the lender will charge you in interest per year on the outstanding balance (for a loan) or the current borrowings (on a line of credit). But the APR includes not just this raw interest cost, but any and all other fees and costs associated with a borrower actually holding the debt. 

These fees will include annual charges, customer service fees, closing costs, broker/agent fees, and rebates/discounts. Because of this fact, when making an apple-to-apples comparison of two loans, it’s best practice to use the APR for both. If you don’t know the APR (even though it should always be prominently stated by a lender), you’ll want to calculate it yourself to give a level view of your choices.  

The process to calculate the APR is intuitive: Start with the total nominal interest costs, and add any expenses and fees charged. Then subtract any rebates, discounts, or points, and divide your new dollar total by the principal amount of the loan or the available line of credit. This is your APR. The APR will almost always be higher than the stated interest rate on the loan, unless you’re getting some pretty massive discounts. 

For home buyers, there are always costs outside the nominal mortgage interest paid on the loan. Many of these costs are incurred at the time of initial purchase. As such, most borrowers have those costs “rolled up” into the total amount of the loan to arrive at a new mortgage amount (principal), which is higher than the money needed to actually buy the home.

Your closing costs, mortgage insurance, and loan origination fees may total $5,000-$15,000 on a home purchase—more than most are prepared to pay out of pocket. The final mortgage balance after all the fees and costs are added in is used to create a new interest amount owed, and it’s this new amount used to calculate the APR.A baseline example would go like this:

A borrower takes out a $300,000 mortgage to buy a $300,000 home. The stated mortgage interest rate is 5%, which would equate to $15,000 in annual interest, or ($15,000 / 12 = ) $1,250 per month. 

But if closing costs of $8,000 were rolled into the mortgage, the final principal amount would go to $308,000, and the 5% interest is then calculated on this new amount, totaling $15,4000/year, or $1,283.33/month. The APR would be equal to ($15,4000 / $300,000 = ) 5.13%.

APR Limitations

While using the APR can be helpful when comparing loans and products from different lenders, it does have some pesky limitations. For one, there may not be consistency in what fees or costs are included in an APR from one lender to another. In the case of a mortgage, there may not be a consistent approach to how things like title fees, appraisals, insurance, document fees, and notary/attorney fees are incorporated into the APR.

Also, the APR will change when someone prepays a loan, paying over the stated amount of the monthly payment, or when someone completely refinances (and closes out) the original loan. In most cases, prepayment will cause the APR to rise, although many people see value in prepaying anyway, either because a lower rate is available on a refinance, or just for the peace of mind of getting a debt squared away early and increasing the current equity in their home.

To help filter through different reporting standards from different lenders, best practice is to lean most heavily on the stated interest rate. The headline rate is the most important cost component over the life of the loan, as it’s the amount you’re being charged on the remaining principal balance each month. If loans from two lenders have the same stated interest rate but different APRs, the one with the lower APR is most likely the best value, as it has fewer fees and costs to the borrower. But again, take the time to dig into the fine print to see if there’s a major cost factor not being incorporated into the stated APR.

Will My Lender Provide Me With an APR?

Yes! Any credit card, auto loan, or mortgage product must provide you with an APR along with all of the fees and costs being included in its calculation. Be sure to read the information carefully, including what potential fees and costs are NOT included in the APR (often penalty fees like late fees that may arise in the future). While far from perfect, the APR is a good early signpost to the real-world costs of holding that debt.

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