You’ve probably heard the term APR hundreds of times, but what exactly does it mean? It’s basically just the interest rate, right? Actually, no. Interest rate is an important component of APR, but it is just a part. Let’s start with what does APR stand for. APR stands for Annual Percentage Rate, and it is intended to incorporate the full cost of getting the loan. It costs money to borrow money, and APR is the tool that will help you most closely compare different loan options. This article will focus on helping you understand what goes into APR, how to calculate APR, and why it matters. We’ll also provide some examples so you can see how to calculate it on your own.
What is the Difference Between Interest Rate and APR?
What does APR mean? Investopedia provides the following definition: “The annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.” In other words, APR is expressed as a percentage of the loan amount (which you probably already knew), but it’s not just the interest rate. APR is how much the loan is going to cost you to get each year, so it includes fees and costs associated with loan closing. APR only covers costs that the lender is incurring, so you won’t see property taxes or homeowners’ insurance reflected in APR. The best way to think of APR is the amount it will cost for the privilege of borrowing money, expressed as a percentage of the amount you are borrowing. As an example, let’s say you are borrowing $100,000, and the APR is 4%. In other words, you are paying $4,000 (4%) for the privilege of borrowing $100,000. Granted, you get to pay most of that $4k over the life of the loan in interest, but some of it will be paid in closing costs at loan closing. If you think of the $100,000 as the product and the $4,000 as the purchase price for the product, it starts to make more sense.
Both APR and interest measure costs of your loan in the form of a single percent, but they measure costs very differently. Knowing the difference could mean you avoid paying thousands of dollars more on your home than you need to. The main difference between APR and interest rate is that interest is one part of APR. Interest rate is the pure cost of borrowing that principal amount on your total loan. However, it does not take into account other added costs, such as discount points, broker fees, some closing costs, and more. These costs are included in the APR as said above since APR takes into account both the cost to borrow and the cost of processing the loan. Unfortunately, many lenders will disclose certain costs that other lenders do include. So, know that you aren’t necessarily comparing apples to apples when you compare APRs. It’s always important to ask a potential lender what costs their particular APR includes in order to know how much you are really paying for your mortgage each year.
Each percentage is more useful than the other in different situations. For example, if you are more concerned about saving money every month, you probably want to focus on interest rate. But if you will likely be in the same mortgage for 20 or 30 years, then you probably want to focus on your overall savings and the APR. However, it’s important to consider both when switching mortgages.
How to Calculate APR
This is where it gets even more interesting. Calculating APR is not very easy, and it involves a bit of guess-and-check to get it done. The good news is that you won’t actually have to calculate APR very often since lenders usually do that for you. If you’re contemplating some possibilities for the future and haven’t selected a lender yet, calculating it can be helpful to make sure you know what to expect when you do meet with a lender, but otherwise, you won’t need to do it very often. To calculate APR on a fixed-rate mortgage, the first step is to add up the loan amount (how much you’re borrowing) with the loan-related fees. So if you’re borrowing $200,000, and have $5,000-worth of fees, the cost would be $205,000. Use a mortgage calculator to apply the interest rate you are working with to the new amount. If your interest rate was 4.5%, and you applied it to $205,000 then added the number of months or years the fixed-rate mortgage was for, you should get $1,038.70 for the monthly principal and interest payment. The next step is to switch the mortgage amount back to $200,000 and increase the interest rate until you get to the same (within a few cents) monthly payment. Doing this for our current scenario should give you an APR of 4.711% (monthly payment of $1,038.60) or 4.712% ($1,038.72).
Sure, you may never be in a situation where you know the fees and the interest rate but you don’t know the APR. However, knowing what goes into APR and how it’s calculated is essential to understanding what a lender is offering you. For example, calculating APR on an ARM loan is very different than calculating it on a fixed-rate loan. This is because the interest rate varies after the fixed period, and no one can predict exactly how much that will cost you in the future. The APR calculation will assume that the interest rate will drop after the initial fixed period and stay at that rate until the end of the loan life. It’s more likely that your interest rate will go up and down during the rest of your loan, so it’s impossible to get a perfectly accurate APR on an ARM loan. In these cases, it’s especially important to ensure your lender is being transparent with you on what the APR is really calculating.
Lowest APR Guarantee
At Low VA Rates, we are certain we can get you the lowest rate and lowest APR around. In fact, we have a “Lowest APR Guarantee” that says if you can find someone with a lower APR than what we offer, we will personally write you a check for $250. But we don’t just focus on saving money here. We also focus on providing top-notch customer service because we truly care about our veteran clients. To find out what APR we can offer you today, call now at 866-569-8272.