An annual percentage rate, or APR, is charged to those who borrow money. It includes interest as well as the fees that come with taking out a loan, such as transaction fees and loan origination fees.
The APR on a loan is important for a borrower to understand, since it measures the overall cost of the loan more accurately than the interest rate, which doesn’t include fees. While APR can apply to credit cards, student loans, car loans, and mortgages, this article will focus on mortgage APRs.
Learn what APR means and how it works:
- What Is APR?
- How Does APR Work?
- How To Calculate APR
- Different Types of APR
- The Limitations of APR
- APR FAQ
- The Bottom Line on APR
What Is APR?
APR means annual percentage rate. It’s the yearly charge imposed on a loan that covers interest and the fees associated with borrowing money. An APR is typically expressed as a percentage, such as 2.43%.
Why is APR important?
Borrowers can use APRs to quickly compare rates and fees from different lenders in a unified fashion. If a loan’s APR is high, then it signifies that the interest and fees on the loan are going to be costly, and the borrower will have to pay more money overall.
How Does APR Work?
The APR on a mortgage represents the loan’s interest rate, which is a percentage of the total amount borrowed, along with certain fees charged by the lender.
These fees include but aren’t limited to:
- Credit guarantee insurance premiums
- Mortgage broker fees
- Loan origination fees
- Transaction fees
While the APR covers some loan-related fees, it’s important to know that the APR doesn’t reflect the total cost of taking out the mortgage, which includes charges such as third-party closing costs.
What’s the difference between a mortgage interest rate and APR?
The difference between APR and interest rate boils down to fees. An APR combines the interest rate and the fees charged for borrowing money. That’s why the APR on a loan is usually higher than the interest rate.
What’s the difference between APR and APY?
While an APR represents the amount of interest and fees on a loan that the borrower must pay, an annual percentage yield, or APY, reflects how much interest someone earns on an investment or savings account over one year. An APY factors in the account’s interest rate and compound interest, which is helpful in determining the growth of an investment.
How To Calculate APR
There are different ways to calculate your APR. You can use an online calculator, such as Experian’s, if you know the loan amount, interest rate, mortgage term, and fees from your lender.
To calculate your APR from scratch, you must know the loan amount, how much interest you owe, the total amount of fees, and the length of your mortgage term. The formula for calculating APR is below:
APR calculation example
To demonstrate how a mortgage APR works, we’ll use an example. Let’s say you’re taking out a 10-year, fixed-rate mortgage of $40,000 on a new home. Your interest rate is 2.25%, and you find out from your lender that fees will cost $600.
If you don’t know how much you’ll be paying in interest over 10 years, you can calculate that total by multiplying your interest rate by the loan amount, and then multiplying the result by the number of years in your mortgage term:
0.0225 x 40,000 x 10 = 9,000
You now have the total interest amount.
- Loan fees: $600
- Total interest: $9,000
- Loan amount: $40,000
- Loan term: 10 years
- Interest rate: 2.25%
To calculate your APR, plug those numbers into the formula above:
When you’re using this formula, start from the top and work your way down. First, add the loan fees and total interest:
600 + 9,000 = 9,600
Your calculation should appear like this:
Then, divide the loan fees and total interest by the loan amount:
9,600/40,000 = 0.24
Here’s what your calculation should look like now:
To arrive at your APR, multiply the result by 100:
0.024 x 100 = 2.4% APR
Different Types of APR
There are two different types of APR when it comes to mortgages: fixed APR and variable APR.
A fixed APR has a set interest rate throughout the loan term. For example, a loan with a fixed APR of 2.87% at the start of the term will have the same charges applied until the end of the term. While it’s possible for lenders to change the interest rate on a credit card with a fixed APR, they must notify the borrower beforehand.
Similarly, the interest rate on a fixed-rate mortgage stays the same throughout the loan term. A homebuyer who wants to have a stable payment amount should choose a fixed-rate mortgage.
A variable APR changes with the conditions of the market. It often references the prime rate, aka the base rate for different types of loans. If the prime rate drops due to an economic slowdown, the interest rate on a loan with a variable APR may decline as well.
This concept applies to an adjustable-rate mortgage, or ARM, where the interest rate will fluctuate depending on market conditions. An ARM may have a lower initial rate than a fixed-rate mortgage; however, the borrower faces potential rate increases with an ARM.
Before choosing an ARM, borrowers should find out:
- How soon their monthly payments could increase.
- How frequently their lender will adjust the interest rate, and if there are limits to how much their rate could change.
- If they can continue to afford their mortgage if the interest rate and monthly payments increase to those maximum limits.
The Limitations of APR
While APR can be a helpful tool to determine the rough cost of borrowing money, it’s not a foolproof way to calculate the total amount you’ll pay over the life of your loan.
Here are a few limitations of APR:
- Some fees aren’t always included and can vary from lender to lender. For example, an APR could exclude home appraisal, notary, or title fees. Lenders may also roll certain fees into other charges to offer a lower APR.
- A variable APR or ARM cannot predict fluctuations in the market. A borrower with an ARM may budget using the rate they were offered at the start of their mortgage term; however, if the interest rate changes, then that estimate will no longer be accurate.
- APRs don’t take compound interest into account. When compound interest is calculated, it includes the additional interest that has accumulated on the principal of the loan. So, with longer loan terms, borrowers end up paying more in interest.
Here are the answers to some common questions when it comes to APR.
A good APR is dependent on several factors, including the prime rate, the loan amount, the loan term, and the buyer’s finances. The interest and fees on your mortgage should be affordable and fit into your long-term financial plan.
Your APR is influenced by many different factors, some of which are within your control, and some of which are not.
These factors include but aren’t limited to:
• Your credit score: A higher credit score opens the door to lower interest rates. Credit scores of 670 to 739 are considered good; scores between 740 and 799 are very good; and scores of 800 and above are excellent.
• The loan amount: Extremely large or extremely small loan amounts may carry higher interest rates.
• Your down payment: Lenders may offer lower APRs if you can afford to put more money down.
• The mortgage term: A shorter term generally comes with higher monthly payments but lower interest rates, whereas a longer term is typically associated with lower monthly payments and higher interest rates.
• Your location: Interest rates can vary by region, so buyers who are exploring their options should use an interest rate calculator based on the location of the home.
• The type of mortgage: Special loan programs, such as Veterans Affairs loans or U.S. Department of Agriculture loans, can be cheaper than conventional loans or Federal Housing Administration loans.
• The prime rate: As mentioned previously, market conditions affect the interest rates offered by lenders. If the Federal Reserve announces a rate hike or cut, then variable APRs and the interest charges on ARMs will typically change as well.
Keep in mind that buyers can negotiate with their lender up until the loan is finalized. You may be able to lower your interest rate or waive some fees, depending on your lender.
Even if you have good credit, your APR might be higher than expected due to some of the factors listed above. For example, if you’re making a small down payment or living in a certain area, or if market factors are driving up the prime rate, your combined interest rate and loan fees may be higher — thus making your APR higher.
The Bottom Line on APR
APR can offer buyers a simple way to compare interest and fees across different lenders. Between a loan’s APR and interest rate, the APR is a more accurate representation of the true cost of borrowing money. While it doesn’t encompass all homebuying costs, APR can be an important tool in deciding which lender to use for a mortgage. A potential borrower should shop around, understand the factors that go into determining their APR, and determine if the APR offered fits within their means and overall financial strategy.