What is APR on a Loan? (How to Calculate, and More)

The APR (annual percentage rate) on a loan is the total cost of borrowing money. Understanding APR is crucial when applying for a mortgage, personal loan, credit card, or real estate loan. The percentage amount greatly impacts the total cost of your loan. Therefore, comparing APRs is the most effective method to discover the best financing offers. 

When applying for real estate financing, a lender typically advertises the loan interest rate prominently. However, additional fees and costs affect the total amount of your monthly payments. Therefore, you must understand the APR to find an affordable loan before purchasing real estate.

This article is a comprehensive guide to understanding loan APRs. This information will help you make an informed borrowing decision when applying for a loan.

What Is APR on a Loan?

The APR on a loan is the actual borrowing costs over a year. It includes the interest rate and additional loan fees. These extra costs include lender fees, underwriting fees, origination fees, and insurance premiums. The APR is a standardized way to help you compare the cost of borrowing between lenders.

The APR is tied to the prime rate—the minimum interest rate banks charge when they lend money. Typically, the prime rate is 3% above the base rate set by the Federal Reserve. 

The Truth in Lending Act (TILA) requires lenders to disclose the APR they charge borrowers. Usually, the lender’s annual rate is in the small print, and you must look hard to find it. 

How APR differs from interest rate

The difference between the interest rate and APR is that APR includes all the fees included in the loan. A mortgage lender charges interest on the amount borrowed—the principal balance. However, the lender also charges origination fees, annual charges, and closing costs to process your real estate loan. 

For example, several lenders could offer similar interest rates on a loan. However, the annual cost of the loan will be more than the bank’s base interest rate. Therefore, comparing like-for-like doesn’t give a true picture of the yearly cost. It is a single factor determining finance charges.

Let’s say two mortgage lenders offer interest rates at 8%. However, Lender 1 has higher closing costs, customer service fees, and annual charges than Lender 2. In that case, the annual percentage rate of Lender 2 will be lower, making the loan cheaper, with lower monthly payments.

Therefore, APR is a broader measure to determine the true cost of borrowing versus interest rates alone.

Types of APR

Real estate loans from banks or credit unions typically offer fixed or variable APRs. However, if you are looking for other financial services—credit cards, auto loans, or personal loans—you may see different types of APR. 

Here is a short guide to five different types of APR:

• Introductory APR: A credit card company may offer special introductory rates to new customers. For example, they may offer 0% APR for the first 12 months, effectively letting you borrow money for free. However, you must read the fine print on the exact terms after the promotional period ends. 
• Purchase APR: This is the yearly rate for a credit card. The APR is the percentage applied to the balance after the credit card grace period expires. For example, a provider could allow 40 days to pay the credit card balance without charging interest. 
• Balance transfer APR: A credit card provider may use incentives to entice you to transfer a loan or credit card debt to their loan services. You pay APR on the transferred balance. Sometimes, the promotional balance transfer APR can be as low as 0%.
• Cash advance APR: Credit card issuers charge a higher credit card APR to withdraw cash from an ATM. Typically, the rate of interest is applied immediately, without any grace period. 
• Penalty APR: You may be charged a higher APR rate if you breach the credit card agreement. For example, late payments could mean paying a penalty on top of the standard APR.

APRs for loans let you compare providers to find the best deals. However, it’s always wise to check the exact loan terms, as you may face tough penalties for breaching terms or not paying the credit card balance within a certain period of time.

Fixed vs. Variable APR

Most banks, credit unions, and mortgage lenders offer fixed or variable APR loans. Understanding how these loans work can affect your financing choices. Because loan terms are typically fixed between 10 and 30 years, the type of APR can significantly affect your real estate investment strategy.

Fixed APR

A fixed-rate loan is where the interest rate remains constant for the loan term. Therefore, the monthly payments for this type of loan remain stable, regardless of market health. This provides stability without concerns about unforeseen hikes in interest rates. 

For example, the interest rate on a 30-year fixed-rate loan doesn’t change from the first day of the mortgage to the last. 

The benefit of fixed-rate APR loans is that you know the monthly mortgage payment, regardless of changes to the base rate. However, you cannot benefit from declining interest rates, and loan agreement terms are typically less flexible. You also may face penalties if you want to exit the loan early.

Variable APR

A real estate loan with variable rates fluctuates based on a benchmark like the prime rate. Therefore, the monthly payment and loan’s annual cost change over time. Lenders usually offer adjustable-rate mortgages (ARMs) with rates lower than a fixed-rate loan. These rates are fixed for a period of time before the adjustable period starts. 

The benefit of variable-rate loans is that monthly payments are lower during the introductory period. Also, you can benefit when base rates fall. 

However, the variable nature of the loan means it is difficult to plan for or forecast future cash flow. And depending on market conditions, monthly payments could rise quickly.

Components of APR

The annual percentage rate includes the lender’s base rate for borrowing money and additional costs. Understanding the components of APR on a loan can help you find the best loan product for your investment needs.

Here are the main factors affecting APR on mortgages:

• Mortgage interest rate: The annual rate of interest is the major component affecting APR. The higher the base rate, the more you pay each month. 
• Underwriting fees: These fees cover the costs the lender incurs to research your financial status. These checks include your credit score, income, bank statements, and financial history. 
• Origination fees: The lender charges these fees for processing the loan application. 
• Closing costs: You must pay fees to cover the costs of appraisers, title insurers, and real estate attorneys. 
• Insurance premiums: Sometimes, you may be required to take out mortgage insurance. In this case, you can choose to include the premium in your monthly mortgage payments. These premiums affect your final APR. 
• Discount points: You can pay higher upfront costs for a lower interest rate. This financial strategy can be wise if you have a loan for a long time, for example, a 30-year loan term.  

When comparing the APRs of loan offers, including all the components the lender uses in their calculations is vital.

Other factors affecting APR

Other factors affect the loan’s actual cost. Here are some other considerations:

• Credit history: Your credit score significantly impacts the interest rate your lender offers. The higher your score, the more likely you can lock in a lower interest rate and APR. Therefore, improving your credit score before applying for a loan makes sense. 
• Loan terms: Loans with longer terms typically result in higher APRs, as they accumulate more interest over time. Therefore, the overall cost of borrowing is greater. 
• Down payment: A larger down payment means borrowing less money and paying less interest. Also, lenders may offer a more favorable monthly interest rate for a larger down payment. A small down payment may increase interest rates and require you to pay for mortgage insurance.
• Debt-to-income (DTI) ratio: Your DTI ratio indicates to lenders your ability to pay all mortgage costs. Typically, financial institutions require real estate investors to have a DTI of 43% to 45%.

APR and Mortgage Loans

The APR—not the interest rate—determines the mortgage loan cost. Of course, lenders are required to tell you the APR. However, understanding how to calculate APR on a mortgage is vital for making wise investments. For example, you can look for ways to lower your APR.  

How to calculate APR on a mortgage

Calculating APR on a mortgage to determine the actual loan cost is relatively straightforward. The components you must know are the loan principal, fees, term, and interest. Next, add the fees and interest and divide by the loan amount. Then, divide the result by the loan term (days). Last, multiply by 365 and then 100 to get the percentage. 

Here is the APR calculation formula:

APR = (([fees + plus interest] ÷ [loan principal]) ÷ [loan term]) x 365 x 100

Despite the calculation appearing to be simple, it gets tricky when calculating the APR of a large mortgage over 15 or 30 years. This is because most home loans are amortized, where you pay the loan’s principal and interest. Therefore, the more you pay off the loan’s principal, the less you pay in interest charges. 

Mortgage APR example

Here’s a simple example of how APR works when calculating total mortgage costs. To make it straightforward, we will use a small personal loan. 

Let’s say an investor applies for a $3,000 loan with a loan term of six months. The interest rate is 6%, and the lender charges $50 in fees. Here is how to calculate the APR:

(($50 + $180) ÷ $3000 = 0.115) ÷ 180 x 365 x 100 = 23% APR

What about a 15-year loan for $250,000 to purchase a rental property? Let’s say the bank offers an interest rate of 8%, and upfront fees are $7,000. The investor would pay $180,044 in total interest, and the $7,000 in fees are spread over the loan term. If you crunch the numbers in an APR calculator, you will learn that the APR is around 8.46%. 

You can use this figure to compare mortgages from different lenders with similar terms. For example, suppose one lender offers a tempting fixed-rate loan of 6.5%, and the APR is 9.5%. However, another lender offers a higher interest rate, but a lower APR. You can determine which of the two deals is best over the loan term. 

A lower 1% APR could reduce loan costs of $5,000 or more over five years, despite having a 1% higher interest rate. 

What is a good APR?

The best APR depends on several factors. Mortgage lenders consider your credit score, loan type, base rate, and market conditions. For example, a shorter-term loan, like a 15-year mortgage, typically has a lower APR than a 30-year mortgage. 

How to lower your APR when applying for a mortgage

Lowering your mortgage APR can result in considerable savings over the loan term. Here are six simple ways to lock in a better mortgage rate:

1. Improve your credit score: Take positive steps to boost your credit history and get a higher score. Typically, lenders offer better APR to borrowers with excellent credit history. Therefore, pay bills on time, reduce debt, and address errors on your credit report.

2. Shop around: Compare mortgage offers from multiple lenders to find the most competitive rates and terms. Use a mortgage calculator to find a mortgage you can afford.

3. Increase your down payment: Consider making a larger down payment to reduce the loan amount and, subsequently, the APR.

4. Choose a shorter loan term: If you can afford higher monthly payments, consider shorter terms to reduce borrowing costs.

5. Consider points: You can lower your interest rate by paying points upfront.

6. Negotiate with lenders: Don’t hesitate to negotiate APR components with lenders. To make sure they secure your business, some may be willing to waive certain fees and costs.

Final Thoughts

The annual percentage rate on loans matters because it impacts borrowing costs. APR gives you the best measure by which you can compare offers from various lenders and calculate the annual mortgage cost. However, understanding APR is not only useful for real estate investors. It’s the benchmark for all types of loans, including credit cards.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.