The cost of credit, including the interest and fees, expressed as an interest rate. APR was created to make it easier for consumers to compare loans with different rates and costs, and by law it must be disclosed in all advertising.
Here’s how APR works. If Lender A offers a $100,000 mortgage at 4.5 percent with no costs, and Lender B offers a $100,000 mortgage at 4.5 percent with $5,000 in costs, it’s obvious that Lender A has the better deal. Both loans have monthly payments of $506.69, but one costs a lot more. But what if Lender B offers a 4.125 percent interest rate for $5,000, with a payment of $484.65? Which loan is the better deal now? APR can help with this comparison.
When a borrower takes Lender B’s $100,000 loan at 4.125 percent for 30 years, the payment is $484.65. However, only $95,000 is actually being loaned if the borrower pays fees of $5,000. So if he or she pays $484.65 a month to borrow $95,000, the interest rate is actually higher than 4.125 percent. In fact, it’s 4.537 percent. Lender A’s loan, however, has no costs – so its APR is 4.5 percent, a better deal.
APR is not a fool-proof shopping tool. It can only be used to compare the same kind of loans – for example, 30-year fixed to 30-year fixed. In addition, the calculation assumes that the borrower will keep the loan for its entire term. If Lender B’s mortgage is paid off early, after the borrower has paid $5,000 in fees but before he or she gets the full benefit of the lower payment, the real APR will be higher.