Whether you’re searching for a mortgage, auto loan or student loan, you’ll probably focus on the interest rate offered by competing lenders. You’ll pay less to borrow money with a lower interest rate, but there is a better way to compare loan products: by looking at the annual percentage rate (APR) that lenders quote you.
After all, lenders don’t provide loans for free, and the fees add up. They usually charge origination, administration, processing and recording fees. And if you’re not paying attention, you might end up spending more for a loan even if it boasts a low interest rate.
What Is APR?
APR is a more accurate indication of how much a loan will cost you. That’s because unlike your loan’s interest rate, the annual percentage rate also includes the fees that lenders are charging to originate your loan. However, APR is accurate only for loans based on simple interest. For loans with compounding interest, such as credit card debt, you’ll need to consider the annual percentage yield, or APY. (More on that later!)
APR allows borrowers to compare loans apples to apples by taking into account fees and any other costs in addition to the advertised interest rate. With APR, borrowers can cut through all of the gimmicks that some lenders use to mask the true costs of a loan.
How Is APR Calculated?
You won’t have to do a lot of math, we promise, but it helps to understand the basics of how to calculate APR.
APR Formula And Calculation
Here’s a look at the basic equation used for calculating APR:
APR = (((Fees + Interest) / Principal / n) x 365 ) x 100
Interest = Total interest paid over life of the loan
Principal = Loan amount
n = Number of days in a loan term
Here’s an example based on this APR formula: Let’s say you’re taking out a loan for $2,000 and you have 180 days to repay it. Maybe you’re also paying $120 in interest on this loan and your lender is charging you $50 in fees. Here is how you’d calculate your APR:
- Add total interest paid over the duration of the loan to any additional fees: $120 + $50 = $170
- Divide by the amount of the loan: $170 ÷ $2000 = 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%.
Loan APR Disclosure
You don’t have to do the math yourself. Comparing APRs isn’t difficult, thanks to the federal government’s Truth in Lending Act of 1968. This law states that lenders must provide you with a disclosure statement that shows you the APR of your loan. The disclosure must also include:
- Any charges
- A list of your scheduled payments
- The total amount of dollars it will cost to repay your loan if you hold it until the end of its term
APR Vs. Interest Rate
Say you’re applying for a 30-year fixed-rate mortgage loan. One lender might offer you an interest rate of 3.5%, and a second might offer one with an interest rate of 3.625%. You should go with the 3.5% loan, right?
Maybe. But first you should compare the loans’ APRs, which will tell you how much each loan costs you each year when your lender’s fees and charges are included. Maybe that first loan, with the lower interest rate, has an APR of 3.825% and the second loan’s APR, despite that higher interest rate, is just 3.75%. This means that the second loan, despite coming with a higher interest rate, is cheaper.
How can this be? Simple: The first lender is charging higher fees, which makes its loan more expensive.
APR Vs. APY (Annual Percentage Yield)
There’s another important number to consider when taking out a loan or applying for a credit card: the annual percentage yield.
APR is a measure of the yearly cost of your loan if your loan is based on simple interest, and APY is used in cases where interest is compounded, such as with savings accounts or credit card debt. In the APR calculation example, the borrower paid $120 in interest for a $2,000 loan. That means that they were charged 6% of the principal, calculated once. That’s simple interest.
Sometimes, however, interest on your loan is compounded, or calculated at a regular interval and then added to the principal owed, so that when interest is next compounded, it is calculated using the now higher principal amount. This is how credit cards and adjustable rate mortgages work. APY represents the annual cost of your credit card or loan while also factoring in how often interest is applied to the balance you owe on the card or loan.
What Factors Influence Interest Rate And APR?
What do lenders and credit card providers look at when determining the interest rate and APR you’ll pay on loans and credit cards? Well, there’s a lot.
In general, if your credit score is low and your credit reports contain missed or late payments, you can expect to pay a higher interest rate and APR. If your score is strong and your reports are clean, your interest rate and APR will be lower.
Lenders will also check your debt-to-income (DTI) ratio, which measures how much your monthly debts consume of your gross monthly income. Lenders worry that if your debt is too large compared to your monthly income, you’ll struggle to pay back your loan on time. In general, according to the Consumer Financial Protection Bureau (CFPB), lenders want your total monthly debt – including your new estimated loan payment – to equal no more than 43% of your gross monthly income. If your DTI is higher than this, your lender might boost your interest rate and increase your APR at the same time.
The closing costs that lenders charge also play a key role in your loan’s APR. Lenders charge fees for checking your credit, reviewing your loan documents and processing the paperwork needed to close your loan. If your lender charges higher fees, your APR will be higher. If their fees are lower, the APR will be lower, too.
What Does APR Mean For You?
You don’t want to pay more than is necessary to borrow money. Lenders know that borrowers will be enticed by a rate that’s lower than one offered by a competitor. Shopping around based only on interest rates, though, could inadvertently cause you to spend more than you should on a loan.
APR is a valuable tool to help you choose wisely. But remember to take your personal situation into account too. Think about how long you plan to live in a home. If you are buying your forever home, you’ll want the mortgage that is cheapest in the long run. If you plan on moving in five years, focusing solely on APR, or the cost of a loan over its lifetime, might not make sense.
Learn More About APR And Plan Your Financial Future
Credit and debt are going to play a big part of your financial future. Learn more about debt and credit best practices and how leveraging APR can help you make smart decisions in our Learning Center.