What is APR and How Does it Work?

by | Dec 16, 2019

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When lenders talk about mortgages, there are two items that are always brought up together: the annual percentage rate (APR) and the interest rate. Interest rate calculates the monthly payment of the mortgage while the APR calculates the total annual cost of the loan. In this article, you will learn how APR works and how you can use that to your advantage when getting a mortgage.

What is Interest Rate?

Interest rate is a very important factor when it comes to getting a mortgage. When getting a mortgage to buy your house, you are basically agreeing to finance it and pay for your home in installments. Most people do this because homes are not cheap and most people don’t have hundreds of thousands of dollars lying around to buy a house in cash. The interest rate determines how much extra you will be paying in addition to the principal, which is the amount that you borrowed.

The interest rate that you receive is determined by several factors such as the type of mortgage you choose, when you choose to buy a home, your credit score, how much debt you already have when applying for a mortgage, etc. How much you pay in interest depends on the interest rate and your loan amount so if you have a higher interest rate, you will be paying more in interest.

What is APR?

The Annual Percentage Rate (APR) is listed alongside the interest rate when looking at the current mortgage rates. This is required by law so that consumers will be able to look at the different rates that different lenders are offering and see which would benefit them the most. While interest rate helps to calculate the monthly mortgage payment, the APR includes the fees that you pay upfront in order to get the loan. This was put into place so that things would be clearer between the lender and the consumer.  The annual percentage rate is the what your lender charges you to borrow money.

In 1968 The Truth in Lending Act was put into place so that the consumer would have a better idea of the situation they were about to get themselves in. This ensures that consumers are not taken advantage of and instead properly educated about the true terms and cost of the loan by the lender.

How does APR work?

An example of APR at work:

Person A goes to the bank and takes out a $30,000 auto loan at 8% fixed APR for seven years.  If this person makes all of their monthly payment on time, they would have paid their lender about $39,000 by the end of the term of the loan.  $30,000 for the initial loan amount and about $9,000 in interest charges.

Credit cards, however, are different in that if you pay your full balance each month by the due date, you can avoid interest and your APR will have no effect on the cost of borrowing money.   This is because interest charges are either simple or compound interest, and is based on what your credit card issuer applies.  While personal loans, auto loans, student loans are all simple interest loans, credit cards can be compound interest loans where interest charges are calculated on the outstanding balance (new purchases included) and the interest itself.  With interest rates, it’s important to have an understanding of what type of interest your loan is applied to, as to truly avoid the negative effects of compounding interest is to pay off your balance in full each month by the due date, especially since card issuers typically offer a grace period where interest won’t be charged if fully paid.

What are different types of APRs?

As shown above, APR is different based on if you are applying for a loan or a credit card.  With credit cards, your interest rate and APR will be the same number as there are no fees to add to a credit card’s interest rate to get a different APR.  With credit cards in particular, you will see that there are many different APRs that credit cards will be called out by credit card companies and we’ve listed them below along with a simple explanation of what they entail:

Balance Transfer APR

This is the APR you will get for a balance transfer when you are looking to transfer the balance of one card to a new card.  This may be different than your current card’s purchase APR.

Purchase APR

This credit card APR is the price that you will pay on your purchases if you do not pay off your balance at the end of each billing cycle.

Intro APR

The introductory APR is what is what credit card companies will sometimes offer as a 0% APR for new purchases to encourage sign-ups for their cards.  After this intro ends, the purchase APR will take over.

Cash Advance APR

If you are taking a cash advance against your credit card, this APR will be different and often higher than the purchase APRs on certain cards.  Some cash advances can get around 27.99%.

Penalty APR

If you have a late payment, some credit card providers will charge you with a higher APR that comes in after you miss that payment.  Missed payments can also affect your credit score so be careful to pay your balances on time.

Will the APR Affect My Monthly Payment?

In regards to the monthly payment, APR won’t affect it at all. Its main function is to provide more insight to the consumer of what exactly they are getting themselves into. Simply put, a higher APR would result in higher payments over the life of your loan.

What Does the APR Include?

Because APR includes the total cost of the loan including the interest, the APR will usually be higher than the interest rate. Usually the APR will include loan origination fees, closing costs, broker fees, etc. Basically, the APR should include most financial costs that you pay directly to your lender.

If you are a veteran applying for a VA Loan, the APR will most likely be higher. Even though a down payment and mortgage insurance are optional and VA Loans have competitive rates, there is a VA Funding Fee that is included in every VA loan in addition to the closing costs. Likewise, the MIP (Mortgage Insurance Premium) for FHA (Federal Housing Administration) Loans will be factored into the APR.

Does the APR Ever Exclude Mortgage Costs?

Yes, there are some cases where certain things are not included in the APR. APR usually includes financial transactions that you pay directly to your lender. If you are paying for property taxes and homeowners insurance with your mortgage payment through an escrow account, these will not be included in the APR. The term “escrow” means that a 3rd party is involved to help facilitate a transaction between two parties. Because a third party is involved, these are not factored into the APR.

Additionally, property taxes and home insurance premiums are not paid to the lender, they are collected by your local government and the insurance company. Home appraisal, home inspection, title insurance and other third party loan fees are also not included in the APR because while they were required by your lender, it was done by a vendor rather than the lender itself.

Be Careful of Advertisements

While many lenders advertise the current mortgage rates with the APR, please keep in mind that these rates are not guaranteed. Just because a lender is showing that they are offering interest rates as low as 3%, it does not necessarily mean that you will be getting that rate. As mentioned before, there are different factors that play a role in the final interest rate that you receive. If you don’t happen to have the best credit or if you have good credit but a lot of debt, you will most likely be getting a higher interest rate than what was advertised. You cannot know what the estimated APR will be until the interest rate has been determined.

Don’t Always Go For the Higher APR, Sometimes Lower APR is Better

When an APR is higher, it usually means that there are more upfront costs that have been factored in it. For example, closing costs are usually paid out of pocket and upfront when getting a home loan, but you can also choose to pay for your closing costs with your monthly payment by opting for a higher interest rate. Because there are now no upfront costs, the APR will be lower. If you aren’t planning on living in your house for very long, a lower APR can benefit you because you will have saved money.

If you paid for the upfront closing costs and discount points to secure yourself a higher APR (but lower interest rate), but had no plans to live in the home for more than 4 years, you will end up paying more for the time that you were living in the home than if you had opted for a lower APR. If you plan on staying in the home for a long while, then paying the closing costs and discount points will be a good idea because over the life of the loan, you will be saving more money.

Who Would Want To Take Advantage of a Lower APR?

If you are only planning on staying in your home for only a handful of years, a lower APR would make the total cost of your short-lived stay cheaper than if you had opted for a higher APR. You could also take advantage of an ARM (Adjustable Rate Mortgage) and pay less in closing costs while also reaping the benefits of a lower interest rate.

With an ARM, there is a window of time called the initial period. During the initial period, the interest rate is fixed and is also lower than the interest rates associated with 30- Year fixed rate mortgage, even when the term for an ARM is also 30 years.  The initial period is usually for 5 years, but you can choose to have a longer initial period lasting for 7 or 10 years. Since the temporary fixed interest rate is lower, the trade off is that once the initial period ends the interest rate will “adjust” or change itself to reflect the current market.

Before the initial period is over, you will already have sold your home, paid back the loan, and paid less in interest. Pair that with a lower APR and not only will you have taken advantage of the lower interest rate, but you will also have paid less for your living situation overall. Keep in mind that if you want to lengthen the initial period, you will most likely get a slightly higher interest rate than if you were to choose the standard 5 years.

How can I get the lowest APR possible?

The lowest APRs are usually given to those with excellent credit, typically looked at those with credit scores above 750.  Credit scores look at your payment history, credit utilization and any new credit inquiries in a short period of time that appear on your credit report.  In order to get your credit score higher to get that low APR, you should make sure to always pay your balances in full and make sure your credit utilization is low.

Overall Thoughts

APR is a great comparison tool to see how much you will be paying to lenders because it encompasses how much you’ll be spending on your loan on an annual basis. A lower APR can benefit the home owner if they are planning on moving in several years. If the situation changes and the homeowner later decides that they want to stay, they can refinance their mortgage and try to get a lower interest rate. While they will have to pay for the fees that come with getting a new loan, they will be saving more money by paying for the upfront costs over the life of their loan.  It makes sense to shop multiple lenders to find the lowest APR for your situation and use this as a significant factor in making your choice.

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