APR: What Annual Percentage Rate Means and How to Use It
APR, interest rate, nominal and effective rates explained with worked examples, plus why total cost beats APR when you may move or refinance.
If you’ve ever applied for a loan or paid off a credit card bill, chances are you’ve come across the term APR, or annual percentage rate (opens in a new tab). But the difference between nominal and effective rates, APR and interest, can stymie anyone. We’ll break down how APR is calculated, and how you can use it to evaluate a loan.
Compounding: More powerful than Superman and ninjas combined
When you see a loan, you’ll typically see the “rate” – that’s actually the nominal APR, or the amount that your loan balance is charged every month, multiplied by 12. If your rate is 4.8%, you’ll be charged 0.4% of your remaining balance every month (4.8% / 12). But this doesn’t take into account compounding, where the charges get added back into the loan balance, thus accruing interest, thus adding to your loan balance…in the end, you’ll owe a lot more than 12 months * 0.4% monthly interest * your balance.
Consider: if you were to borrow $1,000 from a friend at a monthly interest rate of 0.5%, how much would you actually pay them back at the end of the year? At first glance, it may seem like the answer would be $1060 (12 months * 0.5% * $1,000), but that wouldn’t take into account the effects of compound interest.
Instead of being charged 6% one time, the $1,000 loan is accruing 0.5% interest a month, and the interest gets added back into the outstanding loan balance, so at the end of month one, the amount will be $1,005.
At the end of the next month, the 0.5% interest rate is applied to $1,005, not the original amount, so your outstanding balance would be $1,010.03. Finally, at the end of 12 months, you’ll have to pay back $1,061.68, for an effective interest rate of 6.168%. This might seem like a marginal difference, but with six-figure loans and decades on the line, it adds up quickly.
APR, interest rate, tomato, to-mah-to?
There are actually four terms you’ll need to know:
- Nominal interest rate, or the amount that’s charged on your loan balance in a given period of time
- Nominal APR, or the nominal interest rate multiplied by the number of periods in a year
- Effective interest rate, which is expressed annually and accounts for compounding, but not fees
- Effective APR, which typically accounts for both compounding and any fees charged on the loan
Note that effective APR usually also accounts for fees charged on the loan. With a mortgage, where you pay most fees upfront and they aren’t added to the loan balance, you add up the fees paid and divide by the total loan term. Let’s go back to the example of a $1,000 loan with a 6% nominal interest rate. We’ll further say that your friend charges a $50 upfront fee that isn’t added to your balance.
To review, the interest rate is the rate used to calculate the amount of interest charged each period. When multiplied by the number of periods in the year, you get your nominal APR. The effective interest rate includes compounding, while the effective APR includes both compounding and fees.
Using APR to evaluate mortgages
What do all these numbers have to do with evaluating your mortgage or other similar loans? Well, unlike a $1,000 one-year loan, mortgages are generally 15-30 year loans for hundreds of thousands of dollars, and the effects of compound interest can mean that the difference between 3.75% and 3.85% will add up over the years. Generally speaking, the higher the APR, the higher the payments over the course of the loan.
Let’s look at two loans and see how the numbers play out over the course of the loans. Note that both of these are fixed rate, and not variable rate, mortgages. The first is a 30-year, $300,000 mortgage with a 6% APR. Your monthly payment would be $1,798.65. Over the course of 30 years, the total interest paid would be $347,514, for a total payment amount of $647,514.
If, however, we were to take out the same mortgage with a 4% APR and $40,000 in one-time fees paid upfront, we would end up paying $1,432.25 for 360 regular payments. At the end of 30 years, you’d pay $215,610 in interest, for a total cost of $255,610. Three decades on, paying the upfront fee was clearly a good idea.
But what happens if, after 5 years, you decide to sell your house and move across the country? Is the lower APR, one-time fee mortgage still the best deal? Because of the amortization schedule of a mortgage, your first 20 years of payments could be going primarily to interest. Using the example above, a couple looking to sell their house and move after 5 years still has $279,163 and $271,342 left on the 6% and 4% mortgages, respectively.
Adding up the remaining balance, the payments already made and the upfront fees, the 6% loan would cost $387,082, and the 4% loan would cost $397,277. If you plan to stay in your home less than the full loan term, using APR isn’t the best way to gauge the total cost.
So how do you compare two home loans?
When considering mortgages, be sure to make sure that you’re looking at both the interest rate and the effective APR, as well as any fees and your own plans to move. Run your own calculations based on when you plan to move. Use an amortization calculator to calculate your monthly payment given the rate and loan balance, and to find what the outstanding loan balance will be when you’re ready to move. Multiply the monthly payment by the months you’ll be in the house, add the remaining balance and any upfront fees, and you’ll arrive at the personalized total loan cost. Use this figure, rather than interest rate or APR, to evaluate mortgages.
One last note – adjustable-rate mortgages are a whole different ball game. Be especially careful when considering these types of loans, as the initial interest rate is often low, but can expose you to much higher rates later on. If you take out an adjustable-rate mortgage, be prepared for much higher monthly payments down the line.