You may have seen something called APR listed on your loan documents when you borrow money. This could be a credit card statement, a mortgage statement, or even a personal loan statement. You may have often asked yourself, “What does ‘APR’ really mean?”. You should understand the math behind calculating an APR to help make informed decisions on which type of loan is best for you.
What Does APR mean?
An annual percentage rate (APR) is the annual rate charged for borrowing money. APR is the cost of credit expressed as a yearly rate. The APR is a broader measure of the cost of borrowing money than the interest rate, since it also reflects the fees paid to obtain the loan. The higher the APR, the more you’ll pay over the life of the loan.
This includes any fees or additional costs associated with the transaction however, APR does not take compounding into account.
Why Use APR?
Some loans may seem confusing because some lenders quote different numbers that may mean different things. Advertisements and brochures may or may not include all fees that you have to pay or may not disclose early pay off fees. This can make assessing the cost of borrowing challenging.
This is where APR can help. An APR can provide you with an apples-to-apples comparison of differing loan types because it typically accounts for every cost related to borrowing.
What the APR Tells You
The APR, by law, must be shown to customers by loan providers and credit card companies. This facilitates a clear understanding of the actual rates applicable to the agreement. Installment loan providers are required to state the APR before an agreement is signed by a consumer. The APR expressed on that agreement reflects an annual rate, regardless if the loan term is shorter than a 12 month period.
The fees included in APR may vary among lenders. The following fees are usually included in the APR, if applicable:
- Underwriting fee
- Loan processing fee
- Private mortgage insurance fee
- Document preparation fee
- Loan application fee
APR and the Truth in Lending Act
Since 1968, the disclosure and calculation of APR has been governed by the Truth in Lending Act (TILA). The U.S. Department of the Treasury gives the following explanation in regards to how the TILA act protects consumers:
- The Truth in Lending Act (TILA) protects you against inaccurate and unfair credit billing and credit card practices. It requires lenders to provide you with loan cost information so that you can comparison shop for certain types of loans.
- The Consumer Financial Protection Agency is an independent agency within the Federal Reserve System responsible for enforcing federal consumer financial laws.
As a consumer, you have protections in place to help ensure that laws and regulations are followed.
How Do APR and Interest Rate Differ?
It’s a common misconception that APR and interest rate are the same. While these numbers could be close, don’t expect them to be exactly the same. More often than not, the APR is usually higher than the interest rate.
Here is an example:
A business owner interested in buying an office building has been offered a $200,000 loan at an interest rate of 6%.
While the 6% may sound good, don’t overlook the fact that this isn’t the APR. The reason is simple — remember the APR includes other costs and fees associated with the loan.
The APR will almost always be higher than the interest rate.
When comparing multiple lenders and loan products, don’t forget to focus on both numbers to get the entire picture of the true cost of borrowing. You may come across a situation in which two lenders offer the same interest rate, but different APRs. The lender offering the lower APR is charging fewer fees and may be offering a better overall deal.
What Determines Your APR?
Lenders use your credit score to determine a loan’s APR, and it’s based on your past credit history, as well as several other factors. When lenders consider borrowers a “high risk,” they will typically charge more for lending the money in case it never gets paid back.
Now that you fully understand the basics of the APR, here are a few detailed questions and answers for additional information.
What is the purpose of APR? APR helps a borrower understand how much they will pay to take on a loan. It also allows them to measure the cost of credit, making it easier to compare loans.
What is the difference between a fixed and variable APR? A fixed APR stays the same for the entire life of the loan, while the rates of a variable APR can go up and down based on an underlying index. Because the interest can go up, the monthly payment can also increase.
Is it a good idea to use an APR calculator? While the lender can provide you with all the calculations you require, it is never a bad idea to use an APR or loan calculator as a way of running different borrowing scenarios. They might help you fully grasp the details of the loan, including how the APR impacts your overall monthly, weekly or daily payment.
What happens if I pay my loan off early? If you pay off your loan early, you will not have to pay the interest for the remaining time of the loan. Simply put, if you pay early, you may save money! However, always check with your lender as some lenders will impose prepayment penalties which will reduce your savings.
If you are looking to borrow money for less than a year, why do lenders quote you the APR? The Truth in Lending Act was designed to promote the informed use of credit and help consumers evaluate various loans products. Lenders are required to disclose the APR in writing and prior to signing, so consumers can compare different lenders on an equal basis and know the true cost of the credit offered.