APR Explained
APR Explained by Coventry Enterprises of America
APR Explained
The Most Important Number on Any Loan
Annual Percentage Rate is the single most useful number for comparing loans, and it is also the number that lenders are most likely to downplay. Understanding what APR is, how it is calculated, and what it does not include is essential knowledge for any borrower. Coventry Enterprises of America has made this guide as clear as possible.
The interest rate on a loan is simply the cost of borrowing the principal, expressed as a percentage. If you borrow $200,000 at a 7.0 percent interest rate, you pay 7.0 percent annually on the outstanding balance. But that number does not include the fees the lender charges to originate the loan.
APR adds those fees back in. Specifically, APR spreads the fees over the life of the loan and expresses the total cost, interest plus fees, as a single annual percentage. On a $200,000 mortgage with a 7.0 percent interest rate and $4,000 in lender fees, the APR might be 7.22 percent. The APR is always equal to or higher than the interest rate. When they are the same, the lender is charging no fees.
The interest rate is always lower than the APR, so leading with the interest rate makes the loan look less expensive. This is not illegal, but it is the reason federal law under the Truth in Lending Act requires lenders to disclose the APR prominently in advertisements and loan documents. The law exists because the interest rate alone does not tell you what you are actually paying.
When you see a mortgage advertised at a specific rate, the first question to ask is what the APR is. A large gap between the two suggests high fees. A small gap suggests low fees. This makes APR the fastest screening tool for loan comparison.
APR includes lender origination fees, discount points paid to the lender, mortgage broker fees, and certain other prepaid finance charges. It does not include third-party settlement costs like title insurance, appraisal fees, attorney fees, recording fees, and prepaid items like homeowner's insurance and property taxes.
This means APR still understates your true total cost of getting a loan. The Loan Estimate form shows total closing costs including third-party fees, which gives a more complete picture. Use APR to compare lenders and the Loan Estimate to understand total upfront costs.
On a 30-year mortgage, the effect of upfront fees on APR is spread over a very long period, so the difference between interest rate and APR is relatively small. On shorter loans, those same fees are concentrated over fewer years, which makes the APR much higher relative to the interest rate. A two-year hard money loan with a 12 percent interest rate and three origination points could have an APR of 15 percent or more.
For revolving credit like credit cards, APR applies directly because there are no fixed origination fees in most cases. The daily periodic rate used to calculate credit card interest is simply the APR divided by 365.