Understanding APR (Annual Percentage Rate)
When taking out a loan, whether it's a mortgage, auto loan, or personal loan, lenders advertise two different numbers: the Interest Rate and the APR. The interest rate is simply the cost of borrowing the principal amount. However, it doesn't tell the whole story.
The Annual Percentage Rate (APR) is a more comprehensive measure of the cost to borrow money. It reflects not only the interest rate but also the points, broker fees, and other charges that you have to pay to get the loan. Because it includes these extra costs, the APR is almost always higher than the stated interest rate.
Why the APR Matters
The Truth in Lending Act (TILA) requires lenders in the United States to disclose the APR to borrowers. This regulation was established to protect consumers from misleading advertising. By comparing the APRs of different loan offers, borrowers can accurately determine which loan is genuinely the cheapest, regardless of how the lender structures their interest rates and upfront fees.
- Loan A: 5.0% interest rate with $5,000 in upfront fees.
- Loan B: 5.2% interest rate with $0 in upfront fees.
Looking solely at the interest rate, Loan A seems better. However, when you calculate the APR, you might find that Loan B is actually cheaper over the long run, especially if you plan to sell the house or refinance within a few years.
What Fees Are Included in APR?
While the exact fees included can vary slightly depending on the type of loan and the lender, the following are typically included in an APR calculation:
- Origination fees
- Discount points
- Mortgage broker fees
- Processing or underwriting fees
Fees that are usually not included in the APR are those paid to third parties, such as title insurance, appraisal fees, home inspections, and credit report fees.