An annual percentage rate, or an APR, is a rate that is charged for borrowing or investing, expressed as a single percentage number. This number represents the yearly cost of funds over the term of a loan, and includes any fees or additional costs associated with the transaction. The APR is generally slightly higher than the interest rate because it includes all additional fees carried with the loan, including origination fee, points, and private mortgage insurance (PMI).
Essentially, the APR is the average annual finance charge divided by the amount borrowed. The APR allows borrowers to compare rates charged by potential lenders, because borrowers have a bottom-line and easy-to-understand number.
By law, the APR must be provided by credit card companies and loan issuers. This facilitates an understanding between the borrower and the institution of the actual rates applicable to the borrower's agreement. An APR must be clearly stated to customers before any agreement is signed, though companies are allowed to advertise interest rates on a monthly basis. In this situation, the borrower must multiply the rate by 12 to achieve APR.
APR is not the same thing as the annual percentage yield, which takes compound interest into account. APRs are used in a variety of ways relating to credit and loans, including credit cards and home mortgages.
There are a number of different types of APRs when it comes to credit cards.
- Purchase APR – the rate applied to credit card purchases
- Cash advance APR – the cost of borrowing cash from a credit card, which is generally high
- Penalty APR – the highest APR that is applied to certain balances when card terms and conditions are violated
- Introductory APR – a low APR introduced for a limited time period
APRs are often referenced in relation to mortgage loans. Here's an example of how it works. Let's say you are going to receive $200,000, which is the total amount of money borrowed. There are extra costs of $5,000, which includes points, application fee, closing costs, processing fee, title fee, and more. With an interest rate of 7.5 percent and a term of 30 years, a loan calculator will find monthly payments to be $1,433.39. To find the interest rate, you need the loan amount, the monthly payment, and the number of months. Using these numbers, the calculator will find the APR to be 7.75 percent.
When it comes to home mortgages, an APR generally provides a more comprehensive representation of what the loan will cost the borrower year over year. However, there are risks involved when relying on the APR to make loan decisions. There is no standard governance over which fees have to be included in a calculation. This means that lenders can choose what does and doesn't make it into the calculation they provide to you.
The calculation itself is also based on a number of assumptions that aren't necessarily true. For example, the APR is calculated on the assumption that the borrower isn't going to sell the home before the mortgage is repaid, pay off the loan early or refinance. It also doesn't take inflation into consideration. Until lenders and borrowers can predict future interest rates, the APR is simply a guideline rather than a predictive number.
The U.S. Department of the Treasury offers a Windows-based Annual Percentage Rate program (APRWIN), which can be downloaded from the Office of the Comptroller of the Currency. The website states that the program "includes relevant finance charge and APR tolerances for verifying the accuracy of annual percentage rates and finance charges on loans secured by real estate or a dwelling."