Whether you’re searching for a mortgage, auto loan or student loan, you’ll probably focus on the interest rate offered by competing lenders. This makes sense: You’ll pay less to borrow money with a lower interest rate. But there’s a better way to compare loan products: by looking at the annual percentage rate that lenders quote you.
Annual percentage rate, better known as a loan’s APR, is a more accurate indication of how much a loan will cost you. That’s because unlike your loan’s interest rate, APR also includes the fees that lenders are charging you to originate your loan.
Lenders don’t provide loans for free. They usually charge origination, administration, processing and recording fees. These fees add up. And if you’re not paying attention, you might end up spending more for a loan even if it boasts a low interest rate.
Here’s a key fact about APR and interest: A loan’s APR will always be higher than its interest rate. That’s because APR includes both your loan’s interest rate and fees. This is why APR is a far more accurate way to determine the true cost of a loan. It’s also why when comparing loans among competing lenders, it makes more sense to look at a loan’s APR than its interest rate.
One lender might charge a lower interest rate than a competitor. But if that lender’s fees are higher, you might still end up paying more for the loan. When borrowing money, then, resist the temptation to focus on interest rates. Focus instead on APR.
What Is APR?
It’s a more-true gauge of how much it costs to borrow money. The APR on a loan includes both the interest rate and the fees that the lender charges.
How To Calculate APR
You usually won’t have to calculate the APR on a loan. Lenders will provide this information to you. But if you’re into math, here’s a look at the basic equation used for calculating APR:
To calculate a loan’s APR on your own, plug the right numbers into the above equation. Here’s an example: Maybe you are taking out a loan for $2,000 and you have 180 days to repay it. Maybe you’re also paying $120 in interest on this loan and your lender is charging you $50 in fees.
To determine the loan’s APR, add your origination fee and total interest to get $170. Divide that $170 by your total loan amount of $2,000. This leaves you with a result of 0.85. Divide that figure by the term of the loan, which, in this case, is 180 days. That comes out 0.00047222. Multiply that by 365 to get 0.1723603. Multiply that by 100 to get an APR of 17.23 percent.
Again, you shouldn’t have to do this math by yourself. Before signing up for any loan, make sure your lender provides you with a document listing not only your loan’s interest rate but its APR.
Why Is APR Important?
You don’t want to pay more than necessary to borrow money. This is why lenders so often promote their lower interest rates: They know that borrowers will be enticed by a rate that’s lower than one offered by a competitor.
Shopping based only on interest rates, though, could inadvertently cause you to spend more than you should on a loan. Just because a loan comes with the lowest interest rate doesn’t mean it’s the most affordable.
Not all lenders charge the same fees to originate your loan. Every lender charges fees. They need to make money, after all. But a loan’s APR gives you a more accurate picture of how much you’ll actually pay for an auto, student, personal or mortgage loan.
APR Vs Interest Rate
Say you’re applying for a 30-year, fixed-rate mortgage loan. One lender might offer you an interest rate of 3.5%, while a second might offer one with an interest rate of 3.625%. You should go with the 3.5% loan, right?
Maybe. But first you should compare the loans’ APRs, which will tell you how much each loan costs you each year when your lender’s fees and charges are included. Maybe that first loan, with the lower interest rate, has an APR of 3.825% while the second loan’s APR, despite that higher interest rate, is just 3.75%. This means that the second loan, despite coming with a higher interest rate, is cheaper.
How can this be? Simple, the first lender is charging higher fees, fees that make its loan more expensive.
Comparing APRs isn’t difficult, thanks to the federal government’s Truth in Lending Act. This law, passed in 1968, says that lenders must provide you with a disclosure statement that shows you the APR of your loan. The disclosure must also include any charges, a list of your scheduled payments and the total amount of dollars it will cost to repay your loan if you hold it until the end of its term.
APR Definition: A Moving Target
Now you know that APR is the key number when determining which loan is the most affordable. APR, though, operates a bit differently depending on whether you are taking out a loan or applying for a credit card.
With a credit card, interest rate and APR will be the same number. That’s because the banks and financial institutions offering credit cards don’t charge fees for this service. There are then no fees to add to a credit card’s interest rate to get a different APR.
What is confusing about the APRs quoted by credit card providers, though, is that there are several different APRs associated with credit cards.
Purchase APR
This is the most important credit card APR. This is the price you’ll pay on your credit card purchases if you don’t pay off your balance by the end of each billing cycle. It’s also the APR most of us are familiar with when applying with credit cards. You know that if your credit card’s APR is 18%, you’ll pay 18%interest on whatever portion of your balance you don’t pay off when your payment is due.
Balance Transfer APR
You might decide to transfer the balance of one credit card to a new card that you take out. The provider of your new card will charge an APR for this balance transfer, and it might be different from your card’s purchase APR. Several credit card providers offer an introductory 0% APR to encourage consumers to transfer balances. Be aware, though, that after this introductory period ends – usually after 6 to 12 months – the APR on what you haven’t paid off will revert to the card’s purchase APR.
Introductory APR
Credit card providers will often offer a 0% APR on new purchases when consumers first take out a credit card. This is designed to encourage consumers to sign up for their cards. After this introductory period ends – again, often 6 to 12 months – your card’s purchase APR will kick in.
Cash Advance APR
It’s never a good idea to take a cash advance against your credit card. Why? The APR that cards charge on cash advances is often higher than their purchase APRs. Some cards will charge a cash advance APR that is as high as 27.99%.
Penalty APR
Making a late credit card payment will cost you. Many card providers will hit you with a penalty APR, a new, higher APR that kicks in if you miss a payment. The rules on this vary by provider, so make sure you do your research before applying for a credit card. Remember, too, that making a credit card payment 30 days or more past your due date could cause your three-digit credit score to tumble.
Fixed APR Vs Variable APR
When taking out a loan, you might have the choice between a fixed or variable interest rate. The big difference between the two? In a fixed-rate loan, your interest rate won’t change. This means that your APR will remain the same (although there are exceptions). In a variable rate loan, your interest rate can change over the lifetime of the loan, usually according to performance of a specific economic index, often the prime rate.
When you take out a variable rate loan, your interest rate might remain fixed for a set period, often 5 to 7 years. After that time, your loan will enter its adjustable period, meaning that the interest rate can now change depending on the performance of whatever financial index it is tied to. If it is tied to the prime rate, for instance, your loan’s interest rate might rise when the prime rate does or fall when it drops.
Your loan will spell out how often your interest rate can change. Some loans allow the interest rate to change once a year. Others might allow it to change once every two or three years. Your loan might also contain a protection spelling out that your interest rate can’t adjust past a certain level.
If you have a variable rate loan or credit card, you’ll also have a variable APR on that card or loan, meaning that your APR can change over time.
However, just because you have a fixed interest rate doesn’t mean that your APR won’t ever change. This is especially true for credit cards. If you make a late payment, for example, your credit card provider might have the right to increase your APR, even if that APR is fixed.
And a fixed-rate mortgage loan doesn’t mean that your monthly payment won’t ever change. That’s because lenders usually require that you pay extra each month to cover the costs of your home’s property taxes and homeowners insurance. These extra dollars are deposited in an escrow account. Your lender will then dip into this account to pay your taxes and insurance on your behalf when these bills are due. If your insurance and property taxes increase, your monthly mortgage payment might, too, even if you have a fixed-rate loan.
What Factors Influence Interest Rate and APR?
What do lenders and credit card providers look at when determining the interest rate and APR you’ll pay on loans and credit cards? Well, there’s a lot.
First, your lender or card provider will look at your three-digit FICO® Score and the three credit reports maintained on you by the national credit bureaus of Experian®, Equifax® and TransUnion®.
Your credit reports list your open credit and loan accounts, how much you owe on these and whether you’ve had any late payments – 30 days or more late – during the last 7 years. These reports also list any foreclosures you’ve filed in the last 7 years, accounts that have gone into collection during the last seven years and bankruptcy filings during the last 7 to 10 years.
The information in your credit report makes up your FICO Score. FICO Scores range from a low of 300 to a high of 850. The higher your score, the better your odds of qualifying for a loan with a low interest rate. Lenders consider a score of 740 or higher to be excellent.
In general, if your credit score is low and your credit reports contain missed or late payments, you can expect to pay a higher interest rate and APR. If your score is strong and your reports are clean, your interest rate and APR will be lower.
Lenders will also check your debt-to-income ratio, a measure of how much of your gross monthly income your total monthly debts consume. Lenders worry that if your debt is too large compared to your monthly income, you’ll struggle to pay back your loan on time. In general, lenders want your total monthly debt – including your new estimated loan payment – to equal no more than 43% of your gross monthly income. If your debt-to-income ratio is higher than this, your lender might boost your interest rate, increasing your APR at the same time.
The closing costs lenders charge also play a key role in your loan’s APR. Lenders charge fees for checking your credit, reviewing your loan documents and processing the paperwork needed to close your loan. If your lender charges higher fees, your APR will be higher. If their fees are lower, it will be lower, too.
APR Vs Daily Periodic Rate (DPR)
While APR is an important number when weighing credit card offers, it’s not the only one. You can also look at your credit card’s daily periodic rate to understand how interest on your card works.
Your card’s daily periodic rate is its APR divided by the number of days in the year and then multiplied by 100. If your card’s APR is 17.8% and the year has 365 days (it’s not a leap year), your daily periodic rate would be 0.049 (rounded up). The formula for getting to that figure is .178/365, which equals .00049. You’d then multiply that figure by 100.
APR Vs APY (Annual Percentage Yield)
There’s another important number to consider when taking out a loan or applying for a credit card: the annual percentage yield, better known as APY.
While APR is a measure of the yearly cost of your loan, it doesn’t factor in how the interest on your loan is compounded. APY, though, does: This figure represents the annual cost of your credit card or loan while also factoring in how often interest is applied to the balance you owe on this card or loan.
What is compounding? It’s when lenders or credit card providers add interest to the balance you owe on these loans or cards. Lenders and credit card providers compound interest in different ways. On some loans or cards, they might add interest to your balance on a daily basis. On others, they might add it on a monthly, quarterly or even yearly basis. When interest is paid on interest, it’s known as compound interest.
Say your credit card provider compounds interest daily. If yours does, your balance at the end of each day is multiplied by the daily interest rate. The resulting figure is then added to your balance. The following day, your credit card provider will charge you interest on a balance that is now slightly higher.
This means that in most cases, your loan’s or credit card’s APY will be higher than its APR. The exception is if your loan compounds once a year. In that case, its APR and APY will be the same.
Here is an example of how APY is calculated:
APY = (1 + Periodic Rate)n– 1
where:
n= Number of compounding periods per year
Problems With APR When Shopping For Mortgage Loans
APR is a good tool when comparing the cost of mortgage loans. It’s not perfect, though. Here are the biggest weaknesses of this measuring tool:
- APR does not include all the fees of taking out a loan. For instance, APR won’t include any attorneys’ fees you pay, the cost of a home inspection, your loan’s title fee or the money your lender charges for running your credit.
- APR is not useful for comparing mortgage loans of different terms. Don’t use it to compare the costs of a 15-year, fixed-rate mortgage to those of a 30-year, fixed-rate loan. Your 15-year mortgage will always come with a higher monthly payment, but, because you will pay significantly less in interest during its lifetime, it will also be less affordable than a longer-term loan if you hold onto it for its entire term length.
- APR is only accurate if you hold onto your loan for its full life. Refinancing, selling your home before paying the loan off in full and paying off the loan ahead of schedule all cause your loan’s APR to be effectively inaccurate.
How APR Factors Into Your Mortgage Payment
Your monthly mortgage payment is usually made up of four factors, the principal balance that you owe, the interest you are charged and the insurance and property taxes you pay. That’s what the common acronym PITI refers to: principal, interest, taxes and insurance.
Your monthly loan payment will be higher if any of these four parts of your payment is high. For instance, your monthly payment will be higher if your property taxes are $8,000 a year than it’d be if they were $5,000 each year.
The same holds true for the interest you pay on your loan. If your interest rate is higher, your monthly payment will be higher, too. Your APR, remember, takes interest into account, along with many of the fees that your lender charges to close your mortgage.
You can generally assume, then, that a loan with a higher APR will come with a higher monthly payment than will a loan with a lower one.
Final Thoughts On APR
Shopping for a mortgage loan, auto loan, personal loan or credit card can be confusing, with lenders and financial institutions throwing plenty of numbers at you. But if you start your comparison shopping by looking at APRs, you’ll at least get a good idea of which loans are more expensive than others.
Just remember, though, that you shouldn’t choose a loan or credit card by its APR alone. Consider how much the fees that aren’t included in a loan’s APR – such as title fees and appraisal fees – will cost you. Consider, too, how comfortable you are with working with a particular lender or whether a credit card comes with valuable rewards programs that outweigh their slightly higher APRs.
Think about how long you plan to live in a home or how you plan to use your credit card. If you plan on moving in 5 years, focusing on APR might not make sense. That’s because APR tells you how expensive your loan is over its entire lifetime. A loan with a lower APR, though, might cost more during its first 5 years than another loan with a higher APR. And if you always pay your credit card balance off in full, its APR might not be as important because you won’t have to worry about interest payments.
Do you have any additional questions about APR? Let us know in the comments below!
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