What is APR? Information for Veterans
You’ve heard that term probably hundreds of times, but what exactly does it mean? It’s basically just the interest rate, right? Wrong. Interest rate is an important component of APR, but it is just a part. APR stands for Annual Percentage Rate, and 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.
So what is APR?
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 (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, 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. 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 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
How do I calculate APR?
This is where it gets even more interesting. Calculating APR is not very easy, and 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, you would have $205,000. Use a mortgage calculator like this one from Bankrate 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, and 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).
Understanding what goes into APR is important
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. Beware, though, because lenders may include some things in APR while other lenders do not. If you’re comparing offerings from different lenders, you should ask each lender what they include in their APR. You may end up choosing a lender with a higher APR because they include all of the costs of getting the loan into it. If a lender does not include some fees into their APR calculation, you can find out how much those fees will be and calculate the real APR using the steps above.