What is APR and How is APR Calculated?

What is APR?When you hear mortgage ads, apply for a mortgage, see a mortgage rate advertised, you will always see the APR right next to the interest rate.  Why is that, and what is the APR?

APR stands for Annual Percentage Rate.  The APR is a calculation that determines what your interest rate would be if you removed the fees from your loan.  The higher the fees the further your APR will be away from your actual interest rate.  The lower the fees the closer your rate and APR will be.

The Annual Percentage Rate is more a measurement of Fees than it is rate.

TIL or the Truth in Lending Law requires that the APR must be displayed with any advertised rate. This is so companies cannot advertise extremely low rates and then tack on high amounts of fees you would then be required to pay to get that rate.

Go ahead and look.  You will never see an add or hear a radio commercial for a mortgage rate without also getting the APR.  Just like you will never see someone in a television commercial actually drinking beer (or any alcohol for that matter), they cannot show the consumption of alcohol.  I guess that is a different article for a different blog though.  Back to APR.

How is APR Calculated?

APR is calculated by first determining the payment of your loan then removing certain fees like points, application fee, closing cost, processing fee, title fee, etc, from the total loan amount and recalculating a new rate from the remaining balance and original payment.

Here is an example.

Let’s say your loan looks like this

  • $100,000 Loan Size
  • 4% Rate
  • 30 year term

In this scenario your mortgage payment would be $477.42.

The closing costs included in the $100,000 were $1,500.

APR would be determined by first removing the fees from the loan size.

  • 100,000 – 1,500 = $98,500

Now calculate a new rate (the APR) using

  • $98,500 Loan Size
  • $477.42 payment
  • 30 year term

The rate calculated here is 4.1257% which would be your APR.

So the whole scenario would be

  • Loan Size: $100,000
  • 30 Year Term
  • $477.42 payment
  • 4% rate with a 4.126% APR

This is how you can see the APR is more a measurement of fees than it is rate.

You can use this information to help determine what advertised loans are better than others.  If you see a 3.5% rate with a 4.5% APR compared to a 4% rate with a 4.2% apr you know which loan is going to be much cheaper and probably the better deal.  Even though option one may have had a lower rate.

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