APR: Annual Percentage Rate
Why is the APR more valuable than the interest rate?
What is an annual percentage rate?
Annual percentage rate (APR) is expressed as a percentage and is a more accurate representation of the cost of a loan as compared to the interest rate. Unlike a loan’s interest rate, APR also includes any fees or additional costs that lenders charge to originate a loan. With this in mind, the APR of a loan will always be higher than the interest rate. APR provides borrowers with a bottom-line number that they can use to easily compare loan rates from multiple lenders.
APR vs interest rate
When comparing loans you should not base your decision on the interest rate alone. Comparing loans based only on interest rates could inadvertently cause you to pay more than you should. Just because a loan has the lowest interest rate does not mean it is the best deal. Every lender charges different fees (processing fees, underwriting fees, document fees, appraisal fees, etc.) to originate a loan. This is why you should use APR as a comparison, as it shows how much each loan costs including lender fees and charges.
The federal government’s Truth in Lending Act makes it easy to compare APRs. This law dictates that lenders must provide you with a disclosure statement showing: the APR of your loan, any fees, a list of scheduled payments, and the total amount of dollars it will cost to repay your loan if you hold it until the end of the term.
How to calculate APR
APR is calculated using a simple formula. First, add the total interest of the loan together with the total fees. Then, divide your new total by the actual loan amount. Then, divide that number by the number of days in the loan term. Finally, multiply that by 365, and then multiply by 100. See below for a closer look at the formula.
As an example, let’s say you take out a $10,000 loan, over a 365-day loan term, and have to pay $500 in interest, plus $100 in fees.
1. Add the interest and the fees together: ($500 + $100 = $600)
2. Divide it by the principal: ($600 / $10,000 = 0.06)
3. Divide that by the number of days in the loan term: (0.06 / 365) = 0.00016438
4. Multiply by 365: (0.00016438 x 365 = 0.0599987)
5. Finally multiply by 100 to get the APR: (0.0599987 x 100 = 5.99%)
6. This means that our APR is 5.99%
Average mortgage APR rates
In the line chart you can see the 10 year trend of average APR rates for both 30-year and 15-year mortgages. As shown, 15-year rates are lower than 30-year rates. This is due to the fact that shorter term loans mean less risk for the lender.
During the course of a loan, borrowers may encounter a scenario where they are unable to make their loan payment. With this in mind, there is one-half the risk of such event happening over 15 years as compared to 30 years. Additionally, debts are paid back quicker on a 15 year term as opposed to a 30 year term, so the lender has less cash outstanding. The decreased lender risk for shorter term loans results in more enticing rates.
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