Why Use APR?
Loans can be confusing. Slick lenders can quote a lot of different numbers that mean different things. In an order to reduce confusion, the US Government passed the Truth in Lending Act. One of the provisions of this act is that lenders quote APR to potential borrowers.
What is APR?
APR allows you to evaluate the cost of the loan in terms of a percentage. If your loan has a 10% rate, you’ll pay $10 per $100 you borrow annually. All other things being equal, you simply want the loan with the lowest APR.
APR Limitations
Unfortunately, all other things are not equal. APR can include more than just the interest cost of a loan. On a mortgage, APR might include Private Mortgage Insurance, processing fees, and discount points. There are other fees and charges that may or may not be included in a given APR quote. Therefore, you need to look closely at each and every APR.
You can’t simply rely on an APR quote to evaluate a loan. You need to look at each and every charge and expense related to your prospective loan in order to judge whether or not you’re getting a good deal. In addition, look at the bigger picture – you need to know how long you’ll be using a loan to make the best decision. For example, one-time charges up front may drive up your actual cost on a loan – even though an APR calculation might assume those charges are spread out over a longer lifetime (and therefore the APR would look lower).
For more discussion, see Get the Wrong Loan by Comparing APR
APR Example
APR seems really easy, but it’s amazing to watch the numbers (and your costs!) change with different scenarios.
Assume you will borrow $100,000, and the lender tells you you’ve got a 7% interest rate. You also have $1,000 in closing costs. The APR on a 30 year fixed rate mortgage would be 7.10%.
To test this, try the math yourself. In Microsoft Excel, follow these steps:
Find the monthly payment for loan and closing costs:=PMT(0.07/12,360,100000)
The format is: PMT(rate,nper,pv,fv,type)
You should have a result of $665.30.
- .07 divided by 12 is the rate (you’re using a monthly rate to find monthly payments)
- 360 is the number of periods (payments or months – 30 years here)
- 100,000 is the present value of your loan (including additional costs)
Next, Solve for the APR:
=RATE(360,-665.30,99000)
The format is: RATE(nper,pmt,pv,fv,type,guess)
You should have a result of .592%. This is a monthly rate. Multiply by 12 to get 7.0999%.
- 360 is the number of periods you pay on the loan (360 months or 30 years)
- - 671.96 is your payment
- 99,000 is the present value of your loan (how much you’re actually borrowing)
Why is the payment higher in the second bullet point above? We need to calculate the payment for this step using an increased loan balance of $101,000 (the $100,000 loan plus $1,000 in fees required to get that loan).
Want to have somebody do the work for you? Try our online APR calculator. You can find out how your loan compares.
