If you’re considering buying a home or taking out another type of loan, you’ll hear the term “annual percentage rate, or “APR,” thrown around frequently. APR is a percentage that represents the yearly cost of taking out a loan.
It’s a good idea to understand how APR works and how to use the formula for calculating yours to make the best decision possible when taking out a loan.
Key Takeaways:
- APR includes both the interest rate and additional fees, making it a more accurate measure of the total loan cost than just the interest rate alone.
- Lenders offer lower APRs to borrowers with higher credit scores, as they are considered less risky.
- A fixed APR remains constant throughout the loan term, while a variable APR fluctuates based on market conditions, potentially leading to higher costs over time.
Is Annual Percentage Rate (APR)?
APR measures the yearly cost of borrowing money, and it includes the interest rate and fees that come with a loan or credit card. APR is a relevant concept for anyone applying for a mortgage, personal loan or line of credit, credit card, home equity loan or line of credit, student loan or auto loan.
When you take out a mortgage, you should consider the cost of the loan in terms of its APR. The APR tells you how much you’ll pay in interest and fees, such as origination fees and closing costs. For this reason, APR is a more accurate metric for comparing mortgage costs than simply looking at interest rates.
The following variables go into calculating APR:
- Interest rate: The interest rate is a fee you pay to the lender for borrowing the money and is a percentage of the loan amount. The lower your interest rate, the less you’ll pay over the life of the loan. A loan’s amortization schedule outlines your payments and how much of each goes toward paying off interest.
- Origination fees: An origination fee is an upfront fee you’ll pay to the lender for processing the loan.
- Closing costs: Closing costs are the fees you’ll pay at the end of a real estate transaction and typically are between 3% – 6% of the home’s purchase price. Your closing costs may be included in the APR if you take out a home loan.
When you apply for a mortgage, you’ll receive a loan estimate from the lender. This document should list the loan’s interest rate and APR.
Compare Mortgage Offers From Verified Lenders:
How Does APR Work?
Your APR is expressed as a percentage, and it helps you understand the total cost of borrowing money. Many people look at interest rates when shopping for a mortgage or loan, but the APR is a better measure of what you’ll actually pay. That’s because the APR is typically higher, expressing the true cost of taking out the loan by including interest and fees.
The APR you receive is largely determined by your credit score, and the higher your score is, the lower your APR will be.
What’s Your Goal?
Buy A Home
Discover mortgage options that fit your unique financial needs.
Refinance
Refinance your mortgage to have more money for what matters.
Tap Into Equity
Use your home’s equity and unlock cash to achieve your goals.
How To Calculate APR
There’s a simple formula you can use to calculate the APR on a loan and understand your loan terms better. But first, you’ll need to know the loan principal, mortgage rate and any additional fees.
The APR Formula
A loan’s APR can be found using a formula and following a few steps. First, add the loan’s fees and mortgage interest charges together. You’ll then divide it by the principal and again by the number of days in the repayment term. Then multiply by 365 and again by 100.
Here’s the formula for calculating APR:
APR = ((mortgage interest charges + fees) / Principal / n x 365) x 100
where n is the number of days in the repayment term.
APR Calculation Example
Here’s an example of using the formula to calculate APR. For simplicity’s sake, we’ll use smaller numbers – as APR is part of any loan, not just a mortgage.
Let’s say you’re taking out a $2,000 loan and have 180 days to repay it. You’re paying an additional $120 in interest and your lender is charging you $50 in fees.
Here’s how you’ll calculate the APR in this situation:
- Add the total interest paid over the duration of the loan to any additional fees: $120 + $50 = $170
- Divide by the amount of the loan: $170 / $2,000 = 0.085
- Divide by the total number of days in the loan term: 0.085 / 180 = 0.00047222
- Multiply by 365 to find the annual rate: 0.00047222 ✕ 365 = 0.1723603
- Multiply by 100 to convert the annual rate into a percentage: 0.1723603 ✕ 100% = 17.23%.
We recommend revising this section to conduct the calculation example on a $400,000 home. Using real-life numbers can help illustrate key points for readers in their quest to understand the direct impact of APR.
Potential home buyers can use this formula to compare loan terms from different mortgage lenders. But keep in mind that there are unexpected expenses that can influence APR, like paying for mortgage points or private mortgage insurance (PMI).
As you’re preparing to buy a home, use a mortgage calculator to help estimate your monthly payments and breakdown.
Ready To Become A Homeowner?
Get matched with a lender that can help you find the right mortgage.
Types of Annual Percentage Rates
There are two main types of APRs you’ll see on a loan offer: fixed-rate and variable-rate loans. Here’s an overview of both types of APRs.
Fixed APR
A fixed APR won’t change over the life of the loan. It’ll stay the same regardless of what happens in the market. This makes it easier to budget for your monthly payments. However, a fixed APR may be higher than a variable APR for the first couple of years. Many 30-year mortgages, 25-year mortgages and 15-year mortgages have fixed APRs, as do personal loans, home equity loans and auto loans.
Variable APR
Variable APR
Variable APR
Variable APR
Variable APR
A variable APR is tied to an underlying index, like the federal prime rate. That means a variable APR will go up or down depending on market conditions. For example, if mortgage rates spike, your loan APR will likely rise, too. Variable APRs often come with a low introductory rate so they appeal to borrowers. For 30-year mortgages, this introductory rate may last several years. But once the introductory period is over, your mortgage rate can rise, increasing your monthly payments. This type of mortgage is called an adjustable-rate mortgage (ARM).
Annual Percentage Rate FAQ
If you want some additional information about APRs, you may find the following frequently asked questions helpful.
The Bottom Line
If you plan to take out a mortgage or other loan, this debt will play a big role in your financial future. It’s important to understand how APR works and how to leverage it so you’ll make good financial decisions.
Remember, having better credit tends to help you qualify for a lower APR. If you’re thinking about purchasing a home in the near future, improve your credit by staying on top of any loan and credit card payments, and avoid taking out new credit before shopping for a mortgage.
Ben Shapiro
Ben Shapiro is an award-winning financial analyst with nearly a decade of experience working in corporate finance in big banks, small-to-medium-size businesses, and mortgage finance. His expertise includes strategic application of macroeconomic analysis, financial data analysis, financial forecasting and strategic scenario planning. For the past four years, he has focused on the mortgage industry, applying economics to forecasting and strategic decision-making at Quicken Loans. Ben earned a bachelor’s degree in business with a minor in economics from California State University, Northridge, graduating cum laude and with honors. He also served as an officer in an allied military for five years, responsible for the welfare of 300 soldiers and eight direct reports before age 25.
