Many people do not know how APRs are calculated or why they are often displayed next to interest rates in ads. It’s simple, once you know the basics.
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APR stands for annual percentage rate. It’s a modified version of the interest rate, designed to give consumers a standardized way to compare the costs of different loans. The federal Truth in Lending Act requires all loan issuers to state the APR before any agreement is signed. In many advertisements for mortgages, you’ll see both the interest rate and the APR.
The differenceThe APR is meant to factor in the fees you have to pay in addition to your mortgage payments, which is why the APR is usually higher than the interest rate.
When you are shopping around for a lender, looking at the APRs can give you a quick way to tell which lenders are charging more in fees. For example, say you need a $200,000 loan, and two different lenders both offer an interest rate of 6%. If one of them states a higher APR, however, you know getting that loan will be more expensive.
Example – Loan amount: $200,000 Lender #1 | Interest Rate: 6% | APR: 6.15% → Fees: $5,000 Lender #2 | Interest Rate: 6% | APR: 6.30% → Fees: $10,000
If you want to know how the math works, here’s the equation:
APR = ((Principal + Fees) * Interest Rate) / Principal Example: 6.15% = (($200,000 + $5,000) * 6%) / $200,000
It’s nice the law requires them to do all that math for you, isn’t it?
APRs provide a rough and ready way to compare loans, but they are not perfect. You still need to evaluate all the lender’s terms carefully before taking out a mortgage. Keep these considerations in mind when you look at APRs: