If you are in the process of applying for a loan, you might be looking for the loan with the lowest interest rate. While lenders announce an interest rate when offering you a pre-approval, the Federal Truth in Lending Act also requires lenders to disclose the Annual Percentage Rate, or APR, of the loan to ensure that borrowers can compare offers accurately.
Calculations in interest, especially in the mortgage industry, can be complex. If you fail to understand how the APR of a loan differs from the interest rate you have been quoted, you may be comparing apples to oranges instead of apples to apples. Here is a straightforward guide to understand APR and why understanding APR is so important.
What is the Definition of APR?
APR is the average finance charge charged by the lender annually. To determine the APR, the lender must add the average annual finance charge, the average fees, and then divide the total by the amount borrowed. Luckily for consumers, lenders must do this calculation so you do not have to worry about using your math skills to come up with an accurate figure.
What is the Significance of Understanding APR?
You probably understand that a loan with an interest rate of 7% has higher interest charges than a loan with an interest rate of 6%. Unfortunately, if you base your opinion on this fact alone, you are overlooking all of the fees and costs that are associated with obtaining the loan and servicing it. The interest rate of a loan does not take any of these fees into consideration, but the APR does.
This percentage rate will include the interest rate that the lender charges as well as any fees you will take on. Because the interest rate and fees are included in the APR, APRs are always slightly higher than the interest rate. Some of the fees included in the stated APR are the origination fee, administrative fees, point charges, premiums charged for Private Mortgage Insurance (PMI), application fees, closing fees, processing fees, etc. If you do not take these fees into consideration, you may select a loan that carries a lower interest but still will cost you more in the long run.
How a Lower Interest Loan May Carry a Higher APR than a Higher Interest Loan
Now that you understand the basics of APR and why knowing this figure is important, it is time to review a real life example. Just because an interest rate on a loan is lower than the rate on another loan does not mean it will have a lower APR.
Lender A charges 6 percent interest with no points, and Lender B charges 6 percent interest with 1 point. While you may assume Lender A is the best choice, they charge a 3% origination fee and Lender B charges an industry low 0.5 percent origination fee. While the point from Lender B will cost you $1000 on a $100,000 loan, the origination fee from Lender A will cost $3000 in fees. This raises the APR and makes the APR for Lender A higher, even though there are no points.
While understanding APR completely can be difficult, understanding why you need to compare APRs of a loan is essential. By taking into account all of the fees you will be paying and how this will equate in terms of interest, you can select which lender you should really borrow from.
This article was written by Richard Craft, an MBA student who loves to share what he learns throughout the web. He writes this for Kanetix, your number one choice when looking for an insurance policy on your home. Saving money by finding the best plan for you can be as important as finding the right investments!
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