What is APR?

You’ve probably heard the term APR hundreds of times, but what exactly does it mean? Some confuse APR with interest rates, but actually, your interest rate is just one component of your APR. Your Annual Percentage Rate (APR) encapsulates the full cost of getting a loan. It can help you closely compare lenders or loan options to see which is cheaper in the long run; because, as you know, your loan amount is never the only cost of taking out a loan.

APR vs. Interest Rates

There are lots of fees and extra costs associated with loan closing. Your APR accounts for all of these, and is expressed as a percentage of the loan amount. It calculates how much money per year you’ll be spending on loan transactions. What’s more, these transactions are only those incurred by the lender, so your APR won’t include insurance or property taxes.

Here’s an example: let’s say you’re borrowing $100,000, and your APR is 4%. In other words, you’re paying $4,000 (4%) for the privilege of borrowing $100,000. Granted, you get to pay most of that $4k over the life of the loan in interest, but some of it will be paid in closing costs at loan closing. Think of the $100,000 loan as the product, and the $4,000 APR as the purchase price for the product.

Both your APR and your interest rate measure the costs of your loan in the form of a single percent, but they do so very differently. Knowing the difference could mean you saving thousands of dollars on your home. The main difference between APR and interest rate is that your interest is part of your APR. Interest rates cover the pure cost of borrowing that principal amount of your loan, but they don’t take into account other added costs like as discount points, broker fees, and some closing costs. When comparing APRs between lenders, know that some lenders may fail to make this distinction for you, or what costs their APR actually includes. So it’s always important to ask a potential lender what APR means to them, in order to know how much you’ll really be paying each year for your mortgage.

Depending on the situation, interest rate percentages and APRs can vary in usefulness. For example, if your priority is to save money every month, then you’ll probably want to focus on getting a low interest rate. However, if it’s likely you’ll be in the same mortgage for 20 or 30 years, then you’ll probably want to focus on your APR and overall savings. When refinancing, it’s important to consider both.

How to Calculate APR

Calculating your APR isn’t very easy; it involves a bit of guessing and checking. The good news is that you won’t actually have to calculate APR very often, since lenders usually do that for you. But if you’re contemplating possibilities for the future and haven’t selected a lender yet, calculating APR on your own can help you know what to expect when you do meet with a lender.

To calculate your APR on a fixed-rate mortgage, the first step is to add up the loan amount and the loan-related fees. So, if you’re borrowing $200,000 and have $5,000-worth of fees, the cost would be $205,000. Next, use a mortgage calculator to apply your interest rate to the sum. Let’s say your interest rate was 4.5%. When applied to $205,000, and then by adding the loan term to that amount, you should get $1,038.70 for the monthly principal and interest payment. Once you’ve done this, switch the mortgage amount back to $200,000 and increase the interest rate until you get to the same monthly payment you got the first time around. Doing this for our current scenario should give you an APR of 4.711% (monthly payment of $1,038.60) or 4.712% ($1,038.72).

Knowing what goes into APR and how it’s calculated is essential to understanding what a lender is offering you. For example, calculating APR on an ARM loan is very different than calculating it on a fixed-rate loan. This is because the interest rate varies after the fixed period, and no one can predict exactly how much that will cost you in the future. The APR calculation will assume that the interest rate will drop after the initial fixed period and stay at that rate until the end of the loan. It’s more likely that your interest rate will go up and down during the rest of your loan, so it’s impossible to get a perfectly accurate APR on an ARM loan. In these cases, it’s especially important to ensure your lender is being transparent with you on what the APR is really calculating.