Wondering exactly what APR is and questioning how is APR calculated? We have all the answers you need to help you discover what the APR is and why it is so important when it comes to interest rates and borrowing money.
What is APR?
APR, or annual percentage rate of charge, refers to the interest rate for a whole year. Rather than looking at a monthly fee or rate charged on a loan or credit card, the number is expressed as an annual rate instead. Many people confuse APR and interest rate, but there is a clear difference between the two. Understanding this can make a huge difference when it comes to your repayments.
If you have a credit card or a mortgage, then it is highly likely you have heard this term before. But have you ever taken the time to work out what it actually means for you? While it doesn’t make much difference when it comes to paying off your credit card, it can make a huge difference to your monthly mortgage repayments. Therefore, it needs to be looked into carefully and calculated properly, especially when it comes to choosing between lenders.
While an interest rate may look good on surface level compared to other lenders, it can be deceiving depending on their APR. We show you why.
Interest Rate Vs APR
Firstly let’s take a look at the difference between an interest rate and an APR. So how exactly does APR differ from the interest rate? Put simply, the interest rate is the cost of borrowing the money. For example, if you borrow $500,000 with a 5% interest rate, this is the principal plus interest. Your interest for the year will be $25,000, or a monthly payment of $2085. Simple, right? So where does APR factor in?
APR on the other hand, includes other costs associated with borrowing money and is calculated as an annual figure. This is what makes the APR a much more effective way of determining the costs associated with a loan. These fees can include broker fees, closing costs, rebates and more. Just like the interest rate, they are often referred to as a percentage.
How Is APR Calculated?
Let’s take a look at the example above. You have purchased a home for $500,000 and we know that the interest owed to the financial institution on top of this is $25,000 a year. But now we have to look into what other costs were incurred in this process, such as:
- Did you pay any closing costs?
- Did you have mortgage insurance?
- Was there broker fees?
- Any other costs?
These fees are added to the original loan, to give you a new loan amount. For example, if these fees amount to $5,000, then your new loan amount is $505,000. The interest rate stays the same at 5%, but a new annual payment is calculated against the new loan amount. Instead of paying $25,000 annually it is now $25,250.
So, how is the APR calculated from all of this?
You need to take the new annual payment ($25,250) and divide it by the original loan amount ($500,000). This will get you 5.05%.
In this scenario the APR is 5.05%, while the interest rate is 5%. As you can see, APR is the figure you need to pay attention to as it actually refers to the amount you will be paying back.
What Does This Mean for Loans?
When it comes to borrowing money for a big loan, such as a mortgage, many borrowers get hung up on simply comparing interest rates. The problem with this is that it does account for any of the upfront costs that are involved with the loan. This can account for a high APR. While the interest rate may have initially looked good, when you factor in the APR, it may not be the best offer out there for you.
The part most borrowers find confusing is when they come across two different lenders, offering the same interest rate with the same monthly repayments, but with different APRs. What this means is that the lender with the lower APR requires fewer upfront fees throughout the process. All in all, this will offer the better deal for you.
Having a clear idea of what an APR is and being able to answer the question how is APR calculated will make huge difference when it comes to taking out a loan. You can use this information to make more informed choices that leave you financially better off as a result.
Australian Lending Centre
Get in touch with the experts at Australian Lending Centre for professional advice about APR’s and how they are calculated. We can help you make informed decisions related to your circumstances without getting lost in the numbers. We are always here to help.