rates vs. 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. 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. 

Annual Percentage Rate (APR) is a way to compare the costs of a loan. Although it’s not perfect, it gives you a nice standard for comparing the percentage costs on different loans. This page covers the basics of APR, and how you can calculate it.

Why Use APR?

Interest rates, and the fees required to obtain a given rate from a given lender can be confusing especially when comparing one lender to another.

What is APR?

The APR allows borrowers to evaluate the costs of a loan in a government standard. This standard requires a calculation using a combination of both the interest rate and fees associated with a given loan, and, through a computer program whose formulas are set by the regulators, takes all of the costs of the costs of the loan an “adds” them to the stated interest rate, thereby creating a unique APR for each rate quote.

APR Limitations

Unfortunately, some lenders, in an effort to avoid penalties from regulators, over disclose the fees that are included in the APR calculation, and include other fees that are not required to be included in the APR. As a result, what was meant to equally compare one mortgage company’s rates and fees on an equal basis to another’s this practice of over disclosure can sometimes negate the whole purpose of the Good Faith Estimate and APR calculation. You’ve heard the saying, Garbage in; Garbage out. Therefore, look closely at each APR to see differences in the fee structure that could contribute to confusion. Remember, Big Valley Mortgage loan officers can help you analyze these documents .

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 be lower).

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)

  • .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)

You should have a result of $665.30.

Next, Solve for the APR:

=RATE(360,-665.30,99000)

The format is: RATE(nper,pmt,pv,fv,type,guess)

  • 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)

You should have a result of .592%. This is a monthly rate. Multiply by 12 to get 7.0999%.