Annual Percentage Rate or APR is used to determine the cost of borrowing. APR or (annual percentage rate) is particularly useful to understand its definition for comparison where mortgage loans are concerned. Every lender may charge a different interest rate whenever you sign up for a loan.
Now when it comes to a home loan, you will end up paying more than just the interest costs, and will have to pay a considerable amount of closing costs and finance or insurance charges, among others. APR is used to compute your true costs of borrowing.
What is APR and Why Use it?
Interest rates, closing costs and other fees are taken into account while calculating APR. Cost as a percentage of the loan amount you pay each year is calculated by the APR.
All things being equal, lowest APR is typically the least expensive. However, it is not as simple as that. Still, APR provides a helpful starting point to compare various interests and fees from different lenders.
For instance, you might accept loan terms from a lender who charges a lower interest rate of 4% as compared to one who charges 4.25%. However, the first lender will prove to be costlier if his closing costs are $5,000 as compared to just $1,000 from the second one. This is where APR becomes useful.
How to Calculate?
Calculating APR can be a straightforward process for payday loans where there is a single repayment and fixed costs. However, calculating the APR for home, auto or personal loans can be a bit more complex.
These loans include finance charges, closing costs and interest spread over the term of loan in monthly installments.
However, you can make it easy by breaking the calculation in two parts:
- Solve for the monthly payment
- Calculate APR using this monthly payment and financed amount
It is best to use spreadsheets for these calculations. Microsoft Excel or Google Sheets can make the process easier. An app or a calculator can make it simpler if you prefer calculating by hand.
Step 1: Solving for Monthly Payments
Enter the total period of the loan in months, in cell A1. Multiply the number of loan years with 12. In cell A2, enter this formula using actual numbers. You will need to convert the interest rate from a percentage to decimal format.
PMT (rate, nper, pv, fv, type)
Here “rate” is interest rate, “nper” is the number of payments, “pv” is the loan’s present value, “fv” is the future value, and type indicates when the payments are due.
This formula can be better explained with this example:
PMT (interest rate/months, total months, loan amount plus fees)
If the interest rate is 8% annually for a loan amount of $100,000with an additional closing fee of $1,000 and the loan duration is 15 years (or 180 months), then the formula will look like this:
=PMT (0.08/12, 180, 101000)
You should get -965.21 as the result.
Step 2: Solving for APR
The second step is relatively simpler. Enter the total loan amount in cell A3 and in cell A4, enter 0. This represents the zero balance you will have when you pay off the loan in full.
Use the following formula in cell A5 to obtain the APR
=RATE (A1, A2, A3, A4)*12
This formula can be better explained as:
=RATE (nper, pmt, pv, fv, type, guess)
For instance, continuing with the above example, you will get a complex result: 0.081651165. Right click and format cell A5 to represent the figure as a percentage with two decimal points. The APR is 8.17% as compared to an interest rate of 7%.
How Does APR affect your Mortgage?
APR has a direct impact on your mortgage payments. Your monthly payments will be higher with a high APR, over the life of your home loan.
APR is complicated and a better comparison factor than interest because it includes closing costs and other borrowing costs as well. Few home loans have additional payments in terms of private mortgage insurance to qualify for the loan.
Any quotes you get from lenders might not include all closing costs. Lenders get to choose the items they make as part of the APR calculation. You need to look carefully while comparing loans to ascertain all costs that form part of the APR.
Short of always calculating APR on your own for every lender, you cannot rely on APR alone while picking out the best loan in terms of cost.
Instead, check every charge simultaneously and ask outright questions from a lender about particular charges. Most lenders do not factor in origination fee while calculating APR. Make a list of the charges appearing in the quote.
APR and One-time Costs
APR calculations do not show a true picture with up-front costs and one-time charges. You need to know the loan duration and how long you will keep it to make the best decision. One-time charges will drive up your immediate costs to borrow.
However, APR calculations will automatically assume these are spread over the full life of the loan. You might experience higher initial payments than you expected. APR typically underestimates the impact of up-front costs when you plan to pay off a loan quickly.
For instance, when you take a 30 year, fixed-rate mortgage of $300,000 with a 6% APR and pay no upfront fee, then your monthly payment comes to $1,798.65. The total repayment over the course of 30 years is $647,515 with an interest amount of $347,515.
However, if you add an upfront fee of $40,000 to this calculation, your APR will come down to 4%. Your monthly payments will be $1,432.25 for 360 regular payments with a total cost of $555,607and interest charges amounting to $215,607.
The up-front fee looks like a good idea. But, what happens when you decide to sell your home after 4 years. You would have paid $16,109 more for your loan with 4% APR and $40,000 upfront fee when compared to what you would have paid upon choosing no upfront fee and 6% APR.
In short, APR is not the best comparison tool, if you do not intend to keep a loan for the full term. You cannot ascertain the true cost of your mortgage by depending upon APR alone.
APR calculation is fairly simple when you use a spreadsheet. But you cannot only depend upon APR rates to choose the lesser expensive loan.
APR does not address one-time costs and upfront fees. These are vital considerations while finding the most financially viable product. However, closing costs, loan term and type of loan also play a major role, which are addressed by APR.