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What Is an APR? Annual Percentage Rate, Explained

what is an apr

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The annual percentage rate, or APR, is how much you’ll pay in interest and other fees when borrowing money (e.g., when you get a mortgage loan or a credit card). APR can also be considered the total cost for borrowing money over a one-year period.

The “and other fees” clause is key here. When home buyers get a loan, they often obsess over the annual rate alone—say, that 5% extra you’ll pay every year for the life of your $300,000 loan. But that’s not where your expenses end, and that’s where APR comes into play.

“The APR includes the interest rate and other charges, which is why it’s usually higher than just your interest rate,” says Michele Lerner, author of “Home Buying: Tough Times, First Time, Any Time.”

What to know about APR, and which fees are included?

People tend to think of annual percentage rate as the “true” amount they pay, because it includes all of the major upfront fees associated with the loan (e.g., closing costspoints, origination fees, and private mortgage insurance). It’s also known as the effective APR.

The APR is also your “apples to apples” number when comparing purchase or refinance loans from various lenders, and keeps you from getting tricked into paying hidden fees. If one lender has a vastly higher APR for the same percentage rate, that means it’s charging you more for borrowing money, and you could end up carrying more debt.

There are some costs that aren’t usually calculated into APR, including the home appraisal, title search, title insurancecredit report, and transfer taxes. (Though taxes are usually considered part of closing costs, they aren’t a lender fee so don’t count toward the APR.)

That said, the appraisal, credit report, title search, and title insurance should normally be fairly minor costs when compared with the cost of the loan. Still, if you’re looking at two very close rates, make sure to examine what’s calculated into the APR. Some lenders might not be including things that other lenders are.

Interest rate vs. APR

So which number is more important, the periodic rate or APR? If you want to make sure you get the best loan for your situation and don’t get into too much debt, it’s important to look at both disclosures.

“The reason you should look at both numbers is that if you just stick to the interest rate, you may not know about the fees associated with your loan,” explains Lerner. “If you focus only on the APR, you could miss out on a lower interest rate.”

Keep in mind that the fees that are included in the APR are paid at closing. In contrast, your interest rate is what you’ll pay as long as you are making monthly payments, which could last as long as 30 years, notes Stephen Rybak, a senior vice president with Guardhill Financial in New York.

Your APR does not include interest compounding. Compound interest is basically “interest on interest.” For example, if you incur an interest charge one month, and you don’t make payments that cover all of the interest expense, you then pay interest on the higher balance that includes unpaid interest. Interest compounding is more important to credit card APRs and personal loans, where the amount of interest you pay to the credit card company or bank may multiply as the balance goes up.

What determines my interest rate?

Even saving a fraction of a percent on your interest rate can save you thousands of dollars. As the prime rate (the rate banks charge one another) goes up and down, so do purchase APRs on mortgages and other debt. If you can purchase a home when you can lock in a good APR, you’ll save a lot of money on interest charges over the life of your mortgage.

In addition, you’ll find different APRs from different lenders. Shop around to make sure you get the best deal.

Six key factors affect the interest rate most mortgage lenders offer at a given time:

Credit score: Your credit score is a numerical representation of your track record of paying off your debts, from credit card debt to student loans. If you have a good mix of credit accounts (e.g., a credit card or two and perhaps an auto loan) and you pay your bills every month, you generally should have a good credit score. Lenders use your credit score to predict how reliable you’ll be in paying your home loan. In general, consumers with higher credit scores receive lower interest rates than consumers with lower credit scores. A perfect credit score is 850, a good score is from 700 to 759, and a fair score is from 650 to 699. Loan amount and down payment: If you’re willing and able to invest a large down payment in your home, lenders assume less risk and will offer you a better rate. (A 20% down payment makes a lender feel a lot more secure than a 10% down payment.) If you don’t have enough money to put down 20% on your mortgage, you will probably have to pay private mortgage insurance, or PMI, an extra monthly fee meant to mitigate the risk to the lender that you might default on your loan. (PMI ranges from about 0.3% to 1.15% of your home loan.) Also, depending on your circumstances or loan type, your closing costs and mortgage insurance may be included in the amount of your loan. Home location: Mortgage rates can vary depending on where you’re buying a home. Indeed, the strength of your local housing market can drive up or drive down interest rates. Loan type: Your interest rate will depend on what type of loan you choose. The most common type of home loan is a conventional mortgage, aimed at borrowers who have well-established credit, solid assets, and steady income. If your finances aren’t in great shape, you may be able to qualify for a Federal Housing Administration loan, a government-backed loan that requires a low down payment of 3.5%. There are also U.S. Department of Veterans Affairs loans and U.S. Department of Agriculture Rural Development loans. Loan term: The duration of your loan affects your rate. In general, shorter-term loans have lower interest rates—and lower overall costs—but larger monthly payments. Type of interest rate: Mortgage rates depend on whether you get a fixed-rate mortgage or an adjustable-rate mortgage (ARM), also called a variable APR mortgage. A fixed-rate means the interest rate you pay remains fixed at the same level throughout the life of your loan. Meanwhile, an ARM is a loan that starts out at a fixed, predetermined interest rate—likely lower than what you would get with a comparable fixed-rate mortgage—but the rate adjusts after a specified initial period—usually three, five, seven, or 10 years—based on market indexes.

How to choose a home loan that’s right for you

Having a hard time choosing between loans based on the interest rate versus APR? If you have the cash upfront but would prefer to have lower monthly payments, it might be worth it to you to shop for the lowest interest rate, even if the APR is slightly higher. In 10 years, you’ll be thankful for that lower interest when you’re paying a smaller bill.

On the other hand, if you need all of your cash on hand for the down payment, you might need to pay a slightly higher interest rate with fewer fees at closing. It also matters how long you plan to stay in the house.

Every loan has a break-even point, where the extra fees you paid upfront are balanced out by a lower interest rate. If your break-even point for a loan with a higher APR and lower interest rate is seven years, but you plan to sell the house in five, you’re getting a better deal with a loan with a higher interest rate and lower fee.

In the end, to get the best deal on a home loan, you’ll want to look at the interest rate, APR, and any details you can get about what fees have been included (or perhaps more importantly, not included) in those numbers.

The post What Is an APR? Annual Percentage Rate, Explained appeared first on Real Estate News & Insights | realtor.com®.

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