What Is APR (Annual Percentage Rate) And Why Does It Matter?

If you’ve ever taken out a loan or opened a new credit card, then APR (annual percentage rate) is a term you’ve probably heard. But what is APR? APR is the rate at which your loan will accrue interest over the loan term.

In this article, we’ll break down everything you need to know, including how APR works, how to calculate it and why it matters.

As the name suggests, APR is a percentage that represents the per-term cost of borrowing money. It’s the rate of interest that buyers pay to lenders over the life of the loan based on an annualized representation of the interest rate.

APR includes your interest rate and all fees that will are applied to your loan or line of credit at closing. For most loans, this may include any or all of the following:

• Base interest rate: The base interest rate is the rate that a lender charges you to borrow money. Your monthly payments are calculated based on this interest rate, which is also included in APR calculations.
• Document preparation fees: These are the fees your lender charges you in order to prepare your loan.
• Underwriting fees: These fees cover the cost of figuring out if you’re eligible for a loan, such as verifying your credit score, bank statements, income and tax returns.
• Origination fee: This is a broad term that includes any fees covering the cost of processing your loan application (i.e., service charges).
• Closing costs: These are the costs to originate your loan that you pay at a mortgage closing or roll into your loan

APR Vs. Interest Rate

The main difference between APR and the interest rate charged to a loan is that the latter is charged to the loan principal. Because the APR includes the loan interest rate as well as all of the other charges and fees listed above, it's a higher percentage. Fortunately, you don’t have to worry about dividing your payments between interest and APR – they’re paid down simultaneously.

APR Vs. APY

Although they may look similar, it’s important to note that a loan’s APR is not its APY, or annual percentage yield. APY is the rate of return you can expect to earn from a savings deposit or investment.

Unlike APR, it takes into account compound interest, which is the process of reinvesting an investment asset’s earnings. Because of this, APY is typically larger than APR. Additionally, APY is the amount of interest you’re earning rather than the interest you have to pay.

When you apply for a loan, there is a cost involved with borrowing that money. APR is the percentage of interest for these services that is paid over the life of the loan.

Ultimately, APR is used as an informational tool to help you compare offers from various lenders. You’ll want to look for a loan with the lowest APR offer. Loans with a lower APR will cost you less to borrow over time than a loan with a higher APR would.

It’s important to note that APR is influenced by your credit score. As with most credit-related matters, the higher your score, the lower the APR applied to your loan. Because of this, it can be a good idea to work on improving your score before taking out a loan if you can afford to wait.

Thanks to the Truth in Lending Act of 1968, lenders are required by law to disclose the APR for any loan they offer before the transaction is finalized. This makes it easier for customers to compare APRs as they shop around. The one caveat to keep in mind is that, because not every lender includes the same fees in their APR, you may have to do a bit more research into the terms and conditions to determine the true value and cost of a loan offer.

If you’re comparing mortgages or loans, it’s a good idea to know exactly how APR is calculated. Having a firm grasp of the concept will better inform your search, and it never hurts to check the math! If you know the amount of fees and interest you’ll be expected to pay on a loan, then determining the APR is relatively simple (although it is always provided for you and you’ll never have to do this):

1. Add the fees and total interest to be paid over the life of the loan.
2. Divide that sum by the loan principal.
3. Divide that result by the total days in the loan term.
4. Multiply the result by 365.
5. Multiply that by 100 to get the APR as a percentage.

What is a good APR for a mortgage?

Because APRs vary from individual to individual and rates fluctuate almost daily, it would be hard to say what a standard “good” APR for a mortgage is. Additionally, APR can fluctuate depending on what type of mortgage you’re considering.

What are the different types of APR?

The specific rates and terms of an APR vary depending on the type of loan it’s attached to. The two main types of APR are fixed and variable.

Variable APR

The interest rate of a variable APR is subject to change at any time during the term of the loan, usually in response to market interest rate fluctuations. This means your APR payments will change as well.

Fixed APR

Conversely, a fixed APR stays the same from the moment your loan is finalized until it’s been paid in full. The interest rate is set by whatever the market rate is at the time the loan was closed. With a fixed APR, you’ll never be taken by surprise should the market interest rate rise. On the other hand, if the rate falls below what it was when you received your loan, you’ll still be paying the higher rate.

Credit Card APR

APR grows more complicated with credit cards. Card issuers are free to charge a different APR for each type of transaction, such as one for purchases, one for cash advances and one for balance transfers. Credit card companies also charge a high-rate penalty APR should the borrower miss a payment or violate the terms of their credit agreement.

Why does APR matter?

If you don’t pay attention to the APR when shopping for a loan or credit card, you could end up paying substantially more over the loan’s term. A loan with an interest rate of 5% and an APR of 10% will still cost you more than one with 6% interest and 9% APR.

The terms of an APR may also influence how you use a new credit card. If there’s a 0% APR introductory grace period, for instance, you may want to make larger purchases during that time. As long as you pay them off in full before the due date when the grace period ends, you’ll be saving money by not having to pay the APR. Just be sure you can pay off those purchases quickly, otherwise, you’ll be saddled with the high-interest charges once the grace period ends.

Shortcomings Of APR

Although it’s important to pay attention to, you shouldn’t assume that APR is always the most accurate indicator of the total cost of borrowing a loan. Why? APR is calculated assuming the loan will be paid off using a long-term repayment schedule. If you opt for a shorter-term schedule, then the actual cost of the loan will be much lower.

Monthly payments on a 30-year mortgage will be much smaller than on a 10-year mortgage, for example, because they’re being spread out across a longer term. But you’ll be paying much more in interest over the life of the loan.

Finally, because financial institutions can decide which fees to include in the APR, it’s difficult to truly compare similar loans and credit cards by APR alone. You’ll need to figure out what’s being included in the APR before you can decide which loan has the better terms. As a general rule, however, the bigger the difference between interest rate and APR, the higher the loan cost.

Can I lower the APR on my credit card?

Most credit cards use a variable interest rate, which means that it changes based on a number of factors. However, sometimes you can negotiate a lower APR with your credit card company by calling them and making a formal request. This option can be extremely beneficial if you’re trying to pay off your outstanding balance or reduce a significant amount of credit card debt.

There are many factors to consider when shopping for a loan, and the APR is definitely one you should not overlook. Be sure you have a firm grasp on the concept of APR, and do the research required to understand the full cost of borrowing. This extra step will help ensure you don’t pay more than you have to.

If you’re looking to compare your options or find out what APR Rocket Mortgage^® offers, you can talk to a Home Loan Expert today.