What Is APR? | APR vs Interest Rate
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When budgeting for a home purchase and calculating monthly payments, a common mistake new homebuyers make is only accounting for interest rate alone. During your mortgage process, your lender will (obviously) disclose your base interest rate, but this percentage value does not include other fees involved in the process. As a result, you might be prepared to cover the monthly costs of base interest payment, without adequately preparing to cover the costs of other charges and fees. This is where the annual percentage rate or APR comes into play.
APR is known as the parameter that reflects the true cost of borrowing and will give you a clearer picture of the costs you’re incurring when getting your mortgage. In this article, we outline what APR is and walk you through the steps of calculating it!
- What is an annual percentage rate? It is simply the sum of your interest rate alongside other fees and charges
- APR gives you a clearer image of the costs that you would be incurring when you take out a loan.
- Calculating APR is simple and straightforward and can either be done manually or using a calculator.
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What Is APR (Annual Percentage Rate)?
What does APR mean? Annual Percentage Rate (APR) serves as a broader form of disclosure or offers full disclosure of all the costs involved in borrowing money compared to the interest rate.
It usually details mortgage broker fees, points, as well as other charges that you are required to pay in order to access a loan. For instance, if payment of the origination fee or points is a requirement, this expense would be noted in the APR. As a result, it comes around to being higher than the interest rate.
Basically, the APR indicates the total interest amount that you would be required to pay annually (averaged over the loan’s full term) on your total mortgage loan amount. In other words, it is regarded as an annual rate and allows comparison among lenders, credit cards, or investment products.
A higher APR interest rate implies a higher monthly interest rate, higher amount of monthly mortgage payments, and vice versa. They are usually included alongside regular interest rates when mortgage rates are being outlined.
Mortgage Fees That Are Included vs Not Included in APR
Common mortgage fees that are included in APR:
- Legal fees
- Origination fees
- Appraisal fees
Common mortgage fees not included in APR:
- Title insurance
- Home inspection fees (if lending bank does not require inspection)
- Mortgage prepayment penalties
- Mortgage default insurance
Why It’s Important To Understand APR
APR provides you with a clearer picture of the money you are spending on your mortgage loan. If you are a first time home buyer, knowing how to calculate APR is crucial in order to avoid getting caught off guard by unexpected lending costs and fees. This is especially important when establishing what you can and can’t afford before shopping for a home.
APR vs Interest Rate: Key Differences
Considering the key differences when evaluating APR vs interest rate requires highlighting what each parameter represents. The interest rate, which is usually expressed in percentages, serves to reflect the present cost required to borrow money.
It does not consider other fees or charges involved without which you would be unable to access said loan. The APR on the other hand presents a clearer and more profound view of the entire cost implication. It usually highlights the interest rate and then includes other lender fees and charges necessary for the loan to be financed.
Do You Pay Both APR And Interest Rate?
The APR comprises the interest rate, alongside other fees. The reason that it is important is the fact that it does include these other fees which are not reflected in the interest rate.
In other words, if you pay your APR, then you have covered your interest rate as well. On the flip side, paying just the base interest still leaves some unpaid fees and charges that the APR highlights.
How to Calculate APR
To calculate mortgage APR, you would need to determine the following criteria first:
- Periodic interest rate on loan (monthly or semi-annually rate)
- Total sum of loan principal
- Number of days in repayment term
- Amount made as monthly loan payments
- Interest and fees charged over the life of the loan
- Discounts applicable
The basic formula is: ((Fees + Interest) ÷ (Principal) ÷ (# of Days in Term) x 365) x 100
Using a basic example, take for instance that your loan amount is $2,000. It has a 300-day loan term, and interest is pegged at $165 with origination fee of $35 required to take out the loan.
To calculate APR in this example:
|Add the origination fee and total interest paid||$165 + $35 = $200|
|Take that number and divide it by the loan amount||$200 / $2,000 = 0.1|
|Divide the result by the term of the loan||0.1 / 300 = 0.00033333|
|Multiply that result by 365||0.00033333 x 365 = 0.1216666667|
|Multiply that by 100 to get the APR||0.1216666667 x 100 = 12.17%|
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Calculating APR on a Simple Interest Loan
To show how APR is calculated on a simple interest loan, here is an example: say you took out a loan of $200 for 30 days. Interest charged is $4, and fee paid is $1. At the end of the 30 days, you pay up the entire loan. APR meaning finance would be calculated like this:
To calculate APR in this example:
|Add the origination fee and total interest paid||$4 + $1 = $5|
|Divide that number by the loan amount||$5 / $200 = 0.025|
|Divide the result by the term of the loan||0.025 / 30 = 0.00083333|
|Multiply that result by 365||0.00083333 x 365 = 0.304166666667|
|Multiply that by 100 to get the APR||0.304166666667 x 100 = 30.41%|
Calculating Amortizing APR on a Mortgage
Amortized loans refer to those that are not paid off at once, rather, they require making regular, scheduled payments periodically. The payments you make comprise a sum that goes to paying off the principal while the other serves as interest. As the principal is reduced, interest payments also reduce, thereby increasing the portion of the payment that is used to pay off the principal.
Calculating APR for an amortized loan does not involve using the exact amount you borrowed. Rather, the average principal balance outstanding for the entire life of the loan is used. You can achieve this by simply splitting your actual loan amount into two.
In the early stages of mortgage repayments, the interest portion is usually larger and then reduces towards the end, making the principal portion increase. At the end of the day, this would make your actual average less than half.
Before manually calculating your APR, an amortization calculator can first be used to calculate actual average principal outstanding.
Here are some frequently asked questions about APR and interest rates.
What is the difference between APR and interest rate?
The interest rate on your loan is the percentage of interest that the lender will charge on your principal balance. Interest payment calculations using that percentage value will not include extra fees and costs associated with the lending process. An APR calculation will include those fees and will give you a better idea of your spending.
What fees are included in the APR?
The APR consists of the interest rate plus other lender fees, which can include legal fees, origination fees, and appraisal fees.
Beyond comparing interest rates, if it is an APR loan, it is important to compare APR before opting for a particular lender. You should look out for a lower APR which would imply lower monthly mortgage payments. Similarly, you can either manually calculate your APR or use an APR calculator.
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