APR stands for "annual percentage rate" and is used to express the total cost of borrowing money. Although the term APR is frequently used interchangeably with "interest rate," these terms mean two different things. So what does APR mean, and how does it affect you when you take out a loan?
What is APR, and how is it calculated?
APR, which is sometimes referred to as "effective APR," is a measure of your overall cost of borrowing. It takes into account your interest rate (sometimes called the nominal APR) as well as any fees that are added to the loan balance. On a mortgage, the APR factors in points and mortgage insurance, if applicable. Because it adds points and other charges, the APR is generally higher than the stated interest rate.
Note that only certain fees are included in the current definition of APR. These include, but are not necessarily limited to, the following:
Included in APR
Not Included in APR
Calculating the APR is a three-step process:
- Add up points and any fees or charges that are charged to originate the loan. Also add in your monthly mortgage insurance premiums until they are expected to drop off the loan— typically this happens once you reach an LTV (loan-to-value ratio) of 78%, but some FHA loans require mortgage insurance payments for the life of the loan. This will give you your adjusted balance.
- Find the monthly payment on the adjusted balance using a mortgage calculator like this one from Bankrate.
- Find the interest rate that would result in this payment using the original loan balance. The result is your APR.
The APR and interest rate can be pretty far apart
To illustrate this process, consider a 30-year mortgage loan for $200,000 at 4.25% interest. We'll say that this loan has total closing fees of $2,000 and that the borrower put 10% down and is therefore required to pay $75 in mortgage insurance per month. Let's calculate the effective APR on this loan.
- $200,000 plus $2,000 equals $202,000. According to a mortgage calculator, the $75 mortgage insurance premium will need to be paid for 84 months, which translates to $6,300 altogether. So, the adjusted balance, including mortgage insurance, is $208,300.
- Adjusted payment based on $208,300 is $1,024.71
- Based on the original balance of $200,000, this payment equates to a 4.6% interest rate. Therefore, the APR on this loan would be 4.6%.
The full picture
To sum it up, the APR on a loan can give you a much better picture of how much it costs you to borrow money than the simple interest rate can. So, when you go shopping for a loan, make sure you look at the full cost of borrowing, which can vary significantly between lenders.