What Is APR?
APR stands for Annual Percentage Rate...and it's something that everyone thinking of getting a loan needs to know. Although APR stands for Annual Percentage Rate, another way to think about it is to think of it as your Actual Percentage Rate.
To define it, it is the annual interest rate charged on a loan(or gained on an investment) after accounting for the base interest rate and all fees associated with the loan, and solved/calculated for the final year of the loan. In the context of this article, APR will be discussed as it relates to borrowing, not investing.
To say it another way, APR is the calculated rate that is typically above and beyond your stated interest rate on a loan. When you walk into your bank and ask for a loan, they may say that they will offer you a loan at an interest rate of 4 percent. Then in the next sentence, they may say that they will charge you a $1,000 origination fee, a $500 application fee and on top of that, you will need to pay for mortgage insurance which will be added to your monthly recurring payment. As you can see, that 4 percent interest rate offer is no longer 4 percent. If this was a 30 year mortgage, your actual APR may be somewhere between 4.5 and 5 percent, or higher.
Why Is APR Important?
APR is important because the interest rate that gets quoted by the lender, isn't always the interest rate that you will pay. This can be important not only when thinking about applying for your first loan, it can be even more important when applying for a mortgage or loan refinance.
APR becomes vitally important when trying to compare loan offers. One lender is offering 4 percent interest with higher upfront fees but another lender is offering 4.25 percent with lower upfront fees. How do you compare your two offers? You will need to calculate the APR of the two offers separately to compare which one is the better offer.
What Fees Can Affect The APR?
Depending on the lender, loan fees can come in many different shapes and sizes. And unfortunately, there is only a loose standard for how APR should be calculated among lenders. However, these are the most common fees that are included in a lender's APR calculation.
- Loan Origination Fees
- Application and Processing Fees
- Underwriting Fees
- Discount Points
- Appraisal Review Fees
- Mortgage Insurance
The following are additional fees that may be charged. Keep in mind that most of these fees are fees that will be charged by an outside company other than the lender and will likely need to be paid regardless of the company providing the loan. Therefore, its not very helpful to include these fees/costs in an APR calculation.
- Credit Report Fees
- Home Inspection
- Lawyer/Attorney Fees
- Title and Escrow Service Fees
How Is APR Calculated?
APR is calculated using a time value of money calculation called IRR or internal rate of return. The IRR calculation measures all cash flows (ie. fees, loan payments, etc.) to calculate an interest rate or cost of borrowing in the final year of the loan.
Is APR The Same During Each Year Of The Loan?
It's important to understand that the APR that loan companies tell you is the APR in the final year of the loan. In other words, they tell you the APR as if the loan will be held for the entire loan term.
However, when a loan is in the first few years, the calculate APR is actually much higher than the APR calculated in the final year. For example, the APR may be 7 percent after the first 2 or 3 years of the loan but as low as 4.5 to 5 percent in the final year of the loan. The point to understand is that the APR trends downward the longer a person holds the loan. This can be explained by the fact that there are typically upfront fees when starting a loan, making the start of the loan more expensive than finishing the loan.
Is The APR Required To Be Disclosed To The Borrower?
As we previously mentioned, there are only loose standards for how the APR must be calculated. However, regardless of how it is calculated, each company must disclose the calculated APR of the loan they are offering. This is required by the Truth In Lending Act and is set forth by Regulation Z 226 inside of TIL.
How Do I Apply This Knowledge To Real Life?
- Understanding how APR works is a very useful thing to know...so how is it useful? First, it can be useful when comparing loans to determine which loan is better for you, the borrower. The APR will potentially put all of the fees and other expenses associated with the loan on a level playing field so that multiple loan offers can be compared, apples to apples.
- Did you know that the average homeowner stays in their home only 6 to 7 years? That means that most homeowners likely sell their home after just living in it 6 to 7 years. Then they move to a different home where they likely start a new loan. If one understands that the APR interest rate trends downward during the life of the loan, then they will know that moving and starting a new loan is an expensive endeavor. In today's interest rate environment, borrowers are likely paying an APR of 5 to 7 percent after just 6 to 7 years. So what? By applying this knowledge, perhaps instead of selling, it might be smarter to turn your old home into a rental property, especially if it can be cash flow positive. This would allow the loan to amortize to the end, where the APR or cost of borrowing is the lowest.
- Knowing that people stay in their homes for a short time, and that the APR is highest in the early years of the loan, it may make you think twice before refinancing. By refinancing, you will start a new loan and once again be in the early years of a loan, where the APR or cost of borrowing is the highest.
We hope you found this article helpful in understanding APR and how it works. By applying the usefulness of understanding APR, a person can save a lot of money during their lifetime when borrowing money. Please leave a comment in the comment section below.
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