What is APR (Annual Percentage Rate)?
When it comes to borrowing money, it is crucial to have a clear understanding of the Annual Percentage Rate (APR). APR is a standardized measure that reflects the total cost of borrowing over a year, including both the interest rate and any additional fees or charges associated with the loan. It provides borrowers with a way to compare the true costs of different loan options. By law, lenders are required to disclose the APR to consumers, allowing them to make informed decisions about their borrowing needs.
APR: Comparing the cost of home loans
When you see a loan rate advertised, you’ll also see a corresponding APR (4.5%/4.762% APR). This Annual Percentage Rate is the total cost of your loan (interest and fees) expressed as a single number. The purpose is to give you one number for comparing multiple loans.
An Imperfect Science: The problem with using APR as designed is that the calculation applies to the entire length of the loan, and most people use mortgage loans for only a few years due to refinancing or sale.
Careful Comparisons: Using APR for comparison can become misleading. Here, you can see the low APR option would cost over $1,500 extra if used for only three years. In the fifth year, the lower APR begins to pay off with a savings of a little over $500.
Tip: The bigger the difference between the rate and the APR, the higher the fees. This is great to know when you see a really low rate advertised. An APR that’s anything more than a quarter of a percent or so higher than the actual rate is a sure indication that the closing fees are really adding up.
Preferences: Another way of looking at this example is to ask yourself whether you prefer $3,000 of savings in the bank or a payment that’s $30 less per month. If you are more comfortable with money in the bank, lean toward lower upfront costs. If you are more comfortable with the lowest possible payment and believe you’ll use the loan for five years or more, then the lower APR alternatives start to make sense.
How APR Influences Loan Costs
The APR plays a significant role in determining the overall cost of a loan. By considering the APR, borrowers can evaluate the true cost of borrowing and make informed decisions. Let’s explore how the APR influences loan costs in more detail.
Firstly, the APR takes into account the interest rate charged on the loan. The interest rate represents the cost of borrowing the principal amount and is a crucial factor in determining the total interest paid over the loan term. A higher interest rate will result in a higher APR, leading to increased borrowing costs. Therefore, it is important to consider the interest rate when comparing loan options, as it directly impacts the APR and the total cost of borrowing.
Secondly, the APR includes any additional fees or charges associated with the loan. These fees can vary depending on the lender and the type of loan. Examples of additional fees may include origination fees, closing costs, or prepayment penalties. These fees are added to the interest rate to calculate the APR. Therefore, a loan with higher fees will have a higher APR, resulting in increased borrowing costs.
Lastly, the loan term also influences the APR and the overall cost of borrowing. A longer loan term may result in a higher APR, as the interest is spread over a longer period. Conversely, a shorter loan term may lead to a lower APR, as the interest is paid off more quickly. It is important to consider the loan term when comparing loan options, as it can significantly impact the total cost of borrowing.
Bottom Line: Lenders are required to disclose APR; it’s our choice to provide this extra information so you can make a truly informed decision about what’s right for you.
Need help? Reach out, and we’ll be happy to assist. Finding the best loan option for you can save you money in the long run and provide you with the financial flexibility you need.