When consumers borrow money from a financial institution, the interest paid on the loan is the largest — but not the only — component of the cost of borrowing money. There are other "hidden" costs and fees that the borrower must incur, such as closing costs or "points" paid on a mortgage. These costs vary by lender and even among different loan options offered by the same lender. This makes it impossible to compare the true cost of different loan offers.
Annual Percentage Rate, or APR, refers to the total cost of borrowing, as the calculation for APR includes not only the interest rate, but also many other fees the borrower might be charged. So APR is seen as the "effective interest rate," a way for borrowers to compare one loan to another (even if it has some pitfalls). When more of a loan's costs are taken into consideration in APR, a loan with a lower interest rate may actually be more expensive than previously assumed.
Examples of Difference
Suppose the principal amount of a loan is $200, the interest rate is 5%, and transaction costs and fees are $6. In this scenario, the amount of money borrowed is effectively only $194 ($200 - $6 in fees). At the end of one year, the interest paid will be $10 (5% of $200). This interest payment of $10 is 5.154% of $194. Therefore, the effective rate that you pay (a.k.a., Annual Percentage Rate, or APR) is 5.154%, even though the nominal interest rate is 5%.
This is exactly what happens in a mortgage. For example, if the mortgage amount is $400,000 but the borrower pays
- 0.5% in "points" (which works out to $2,000), and
- $1,500 in other closing costs,
she is effectively borrowing only $396,500 ($400,000 - $2,000 - $1,500) but paying interest on the full $400,000. That means the real cost of borrowing (APR) is higher than the interest rate that is paid on the $400,000 principal.
Why APR is Used
Due to transactions costs and fees, the APR is always higher than the nominal interest rate (as shown in the examples above). Therefore, APR represents the "true cost" to the borrower and better measures the cost of borrowing.
Another advantage of APR is that it allows the borrower to better compare the cost of borrowing from different lenders, since they may all have different fee structures. One lender may charge a higher interest rate but a lower fees. This may be a better deal than a lender who charges lower interest but high upfront transaction fees. Since APR factors these costs in, the comparisons between lenders are fair and accurate.
While in theory APR should make it easy for borrowers to compare loan offers from different lenders, in practice things are a little more complicated. The Truth in Lending Act requires lenders to include certain fees in their APR calculations, while including other fees is optional. Different lenders calculate APR differently. What's more, the closing date they assume also impacts APR calculation.
Fees almost always included in APR:
- Points, including discount points (money paid upfront to reduce the nominal interest rate) and origination fees
- Various administrative fees that a lender charges a borrower to recoup the cost of doing business (e.g., underwriting fee, loan processing fee, document prep fees, and commitment fee)
- Certain title fees, like insurance and closing costs
- Attorney fees
- Mortgage insurance premiums (either private or for FHA loans) that the borrower needs to pay to insure the lender against the risk of defaulting
- Prepaid interest, which is paid from the time that the borrower closes to the end of the month. Different lenders calculate the number of days differently, based on the closing date or other "rule of thumb" criteria. So this amount may vary by hundreds of dollars, even with the same interest rate.
Fees sometimes included in APR:
- Application fee
- Tax-related service fee
Fees usually not included in APR:
- Appraisal fee
- Credit report fee
- Title fee
- Recording fees
Given the variances in what fees lenders include in their disclosed APR, borrowers need to carefully evaluate loan offers to choose a loan that is best for them.
APR on Credit Cards
When it comes to credit cards, "interest rate" and "APR" are used interchangeably, with APR being the more common term of the two. Unlike the APR on home loans that takes into account interest rates and fees, a credit card's APR simply refers to the amount of interest charged on unpaid balances across a year's time. It does not take into account other costs, such as a possible annual fee for owning the card. Those who have a low credit score or little to no credit history will only be approved for credit cards with high APRs (16% and higher), if they are approved for a credit card at all.
There are usually multiple APRs on a single credit card. For example, many credit cards offer a 0% or low-interest "introductory APR" for up to 12 to 18 months. They also have different APRs for regular card usage (APR on purchases) versus cash advances. (Cash advances almost always have a very high APR.) High-interest penalties — again, shown in the form of an APR — may apply to late payments. Some card companies offer balance transfer deals for a small fee (usually 3% of the transferring balance), and then offer the newly transferred balance 12 to 18 months of 0% or low-interest APR. Some card agreements express a card's numerous APRs in a range, like "12.99% - 22.99%." The 13% APR would likely be on purchases, while the 23% APR might be on cash advances.
Introductory, Fixed, and Variable APR
Most credit card APRs are variable, rather than non-variable or fixed, meaning the issuing card company can change these interest rates as they see fit, with or without notifying cardholders. Credit cards with a fixed APR may still experience an APR change, but the difference is that the card company must contact the cardholder before instituting the new APR. Introductory periods on credit cards are often said to have a "fixed introductory APR," meaning the card company could not decide, six months into the cardholder's owning the card, that it wanted to change the introductory rate.
Paying off a credit card each month is the only way to avoid paying interest on card balances.