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APR: What Is It, How Does It Work And Why Is It Important?

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Published on September 8, 2021
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Whether you’re searching for a mortgage, auto loan or student loan, one of the things you might be focused on is 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 administration, processing, recording and origination 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.

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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 (APY). No need to worry about the difference between APR and APY now, though, as we’ll discuss more on that later.

APR allows borrowers to compare loans 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 Annual Percentage Rate Calculated?

If you’ve never seen or heard of an APR formula, let alone how to calculate it, we’ve got you covered.

APR Formula

Here’s a look at the basic formula that’s used for calculating APR:

APR = (((Fees + Interest) / Principal / n) x 365) x 100

Where:

Interest = Total interest paid over life of the loan

Principal = Loan amount

n = Number of days in a loan term

APR Calculation

Now let’s take a look at 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’s 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 ÷ $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%.

Loan APR Disclosure

Even after learning the APR formula, you still don’t have to calculate it yourself if you choose not to. Comparing APRs shouldn’t be difficult, and thanks to the federal government’s Truth in Lending Act of 1968, it’s not. 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

What’s The Difference Between APR And Interest Rate?

Let’s take a look at the difference between APR versus interest rate with an example. 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 might think that your best option is to go with the 3.5% loan – but the first thing you should do is compare the loans’ APRs. By comparing the two loans, you’ll be able to tell how much each would cost 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 in fact cheaper.

You might be asking to yourself, ”How can this be?” It’s actually quite simple: The first lender is charging higher fees, which makes that loan more expensive.

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.

First, your lender or card provider will look at your three-digit FICO® Score and your three credit reports maintained by the national credit bureaus of Experian™, Equifax® and TransUnion®. 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 with no collections, 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 also be lower.

What’s The Difference Between APR And APY?

There’s another important number to consider when taking out a loan or applying for a credit card: the annual percentage yield.

As previously mentioned, APR is a measure of the yearly cost of your loan if your loan is based on simple interest. 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, which would be the simple interest.

In some cases, interest on your loan is compounded, or calculated at a regular interval and then added to the principal owed. When interest is next compounded, it’s 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.

Common APR FAQs

What is a good APR?

When thinking about what a good APR should be, there are many factors to consider. Those might be your credit score, the interest rate set by the bank or the competing rates that are offered in the market. You’ll also want to be aware of is the length of the term, and whether they’re introductory rates that will end up being a higher APR in the future. A good APR is not one-size-fits-all, so you should consider all these factors and speak to an expert if there’s still confusion.

What is the best mortgage APR?

At first glance, you might want to consider a mortgage loan with the lowest APR, though a lower APR may require you to pay other fees or mortgage points. If you prefer to use that money toward a down payment or other household expenses, you might want to consider a mortgage loan with a higher APR that doesn’t require you to pay fees and mortgage points. Again, APR is not one-size-fits-all.

What does APR mean for you?

You don’t want to pay more than necessary to borrow money. Lenders know that borrowers will be enticed by a rate that’s lower than one offered by a competitor, although shopping around based only on interest rates 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. For starters, think about how long you plan to live in a home. If you’re buying your forever home, you’ll want the mortgage that is cheapest in the long run. If you plan on moving in 5 years, focusing solely on APR or the cost of a loan over its lifetime might not make sense.

The Bottom Line: Understand APR To Plan For Your Financial Future

Credit and debt are going to play a big part in your financial future. It’s important to learn about APR, and the advantages and disadvantages associated with it. By learning more about debt and credit best practices, and how leveraging APR can help you make smart decisions, you’ll be better off in the long run.

Eager for more mortgage-related tips? Consider taking a look at our Learning Center for some more information.

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Call our Home Loans Experts at (800) 251-9080 to begin your mortgage application, or apply online to review your loan options.

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Hanna Kielar

Hanna Kielar is an Associate Section Editor for Rocket Mortgage focused on personal finance, recruiting and personal loans. She has a B.A. in Professional Writing from Michigan State University.