Annual Percentage Rate (APR)
Annual Percentage Rate (APR) is an annual rate that is charged on investments that are borrowed, such as on a home loan or a credit card. It is expressed as a percentage as a way of measuring the full cost of interest payable and other fees. As a result, this number is different and usually higher than your loan’s advertised interest rate.
How the Annual Percentage Rate (APR) is Calculated
APR includes all fees and other charges, as applicable to the loan. These fees may include, but are not limited to:
- Closing costs
- Discount points
- Underwriting fees
- Administrative Fees
- Loan origination fees
- Mortgage insurance
APR takes all these charges and spreads it out over the life of the loan or loan term. In effect, it gives you more information about what you’re really paying by rolling in any up-front fees and charges. However, it does not take compounding into account, which is the role of the Annual Percentage Yield (APY). APY is also known as the Effective Annual Rate (EAR).
APR Versus Nominal Interest Rate
The nominal interest rate is the interest rate or annual cost of a loan to a borrower. Banks and lenders usually advertise the nominal interest rate on their investments. “Nominal” means in name only or simply what is stated. The APR takes the nominal interest rate and includes all other expenses. Naturally, APR is higher than a loan’s nominal interest rate.
For example, a lender may advertise their nominal interest rate to be 4%. You want to purchase a $300,000 home at that 4% interest rate. 4% of $300,000 would mean that you would pay $12,000 in interest for a 30 year-year loan. In other words, you would pay $1,000 a month in interest.
APR tacks on all the fees and charges associated with a mortgage. Let’s say your closing costs, loan origination fee, and mortgage insurance totals $5,000. These fees are added into the original loan amount to create the new loan amount of $305,000. Now, the 4% interest rate is applied. 4% of $305,000 gives you your new annual interest payment of $12,200.
To calculate the percentage of the APR, take your new annual payment and divide it by the original loan amount of $300,000. This gives you 4.06%. Therefore, your mortgage has a 4% nominal interest but a 4.06% APR. The difference is an extra $200.
The Federal Truth in Lending Act, or TILA, protects consumers from lenders and creditors. These series of regulations dictate that the lender must supply the borrower with the APR in addition to the nominal interest rate in every consumer loan agreement. This act ensures the accuracy of the APR so that borrowers can reliably compare the actual loan costs using the APR.