Annual Percentage Rate (APR): What Is It And How Does It Work?
If you’re considering buying a home in the coming year 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 home 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.
What 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. 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.
- 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 cost 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.
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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.
The APR you receive is largely determined by your credit score, and the higher your score, the lower your APR will be. That’s because a high credit score will likely give you a lower interest rate.
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 principal, interest 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 interest 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 = ((Interest charges + fees) / Principal / n x 365) x 100
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%.
Potential home buyers can use this formula to compare loan terms from different mortgage lenders. But keep in mind, there are unexpected expenses that can influence APR, like paying for mortgage points or private mortgage insurance (PMI).
Types Of APR
There are two main types of APR you’ll see on a loan offer: fixed or variable. Here’s an overview of both types of APR.
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.
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. Variable APRs often come with a low introductory rate so they can be appealing to many borrowers. But once the introductory period is over, your interest rate will continue to change.
APR FAQs
If you want some additional information about APR, you may find the following frequently asked questions helpful.
What’s the difference between APR and APY?
APR is the annualized interest plus fees you pay on a loan. APY (annual percentage yield) is the interest you receive on a deposit account (like a savings account) expressed as an annual percentage and including compound interest.
What is a good APR?
What’s considered a “good” APR will depend on your credit score, the interest rate on the loan, or any competing rates offered in the market. You should also consider the repayment terms, whether you’re receiving an introductory rate and if you’ll have a higher APR in the future.
What is APR on a credit card?
APR is the total amount you’ll pay to borrow money with a credit card. A credit card APR is much higher than what you’ll receive on other types of lending products because credit card interest rates are so high. Because of this, it’s a good idea to pay your credit card bill in full each month, if you’re able.
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.
If you want to begin the home buying process, the first step is to get preapproved so you’ll know what type of home you can afford.
