APR (Annual Percentage Rate)
APR explained: what it includes, how it differs from interest rate, and how to compare loan offers correctly.
What APR is
APR (Annual Percentage Rate) is a standardized annual cost of borrowing that often includes certain fees in addition to the interest rate. It's designed for comparing loan offers more fairly than the raw interest rate alone. The Truth in Lending Act (TILA) requires lenders to disclose APR, but what's included varies by loan type. For mortgages, APR typically includes origination fees, discount points, and some closing costs. For credit cards, it's usually just the interest rate. For auto loans, it may include dealer fees. The key is that APR attempts to give you a single number that reflects the true annual cost of borrowing, making it easier to compare offers from different lenders.
APR vs interest rate
The interest rate is the cost of borrowing money expressed as a percentage. APR can include fees and is often the better apples-to-apples comparison metric for loans. If two lenders offer the same interest rate but one charges $2,000 in origination fees and the other charges $500, their APRs will differ. The lender with higher fees will have a higher APR, even though the interest rate is the same. This is why APR is valuable: it helps you see the full picture. However, APR has limitations. It assumes you'll hold the loan for the full term, so if you plan to pay off early or refinance, the APR calculation may not reflect your actual costs. Also, APR doesn't include all fees (like title insurance, appraisal, or prepayment penalties in some cases), so always read the fine print.
How APR is calculated
APR calculation is complex and regulated by the Consumer Financial Protection Bureau (CFPB). The formula accounts for the interest rate, loan amount, term, and certain fees. The calculation uses an iterative process to find the rate that makes the present value of all payments (including fees) equal the loan amount. This is why APR is typically slightly higher than the interest rate when fees are included. For example, a $200,000 mortgage at 6% interest with $3,000 in fees might have an APR of 6.15%. The difference reflects the amortization of those fees over the loan term.
When APR matters most
APR is most useful when comparing similar loan products with similar terms. If you're shopping for a 30-year fixed mortgage, comparing APRs helps you see which lender is truly cheaper. However, APR becomes less useful when comparing different loan types (e.g., 15-year vs 30-year) or when you plan to pay off early. In those cases, focus on the interest rate and total fees separately. For credit cards, APR is straightforward—it's the interest rate you'll pay on balances. For auto loans, APR can vary significantly between dealerships and banks, so always compare APRs when shopping.
Common mistakes
The most common mistakes with APR include: (1) Comparing a low interest rate to a higher APR without checking what fees are included—always ask for a fee breakdown. (2) Mixing compounding assumptions—APR is typically calculated assuming monthly compounding, but some products compound daily. (3) Focusing on monthly payment only—a lower payment might come with a longer term and higher total cost, which APR helps reveal. (4) Ignoring your actual timeline—if you'll pay off early, APR overstates the impact of upfront fees. (5) Assuming APR includes everything—it doesn't include optional fees, late fees, or fees that vary by borrower.
Formula
APR ≈ (Total Finance Charges / Loan Amount) / (Loan Term in Years) × 100Variables:
Worked Example
Scenario:
You're comparing two $200,000 mortgage offers, both at 6% interest for 30 years. Lender A charges $2,000 in origination fees, Lender B charges $5,000.
Steps:
- Lender A: $200,000 loan, 6% rate, $2,000 fees → APR ≈ 6.08%
- Lender B: $200,000 loan, 6% rate, $5,000 fees → APR ≈ 6.20%
- Over 30 years, Lender A's total cost is lower despite the same interest rate
- If you plan to stay 7+ years, Lender A is better. If you'll move in 3 years, the higher fees might not matter as much.
Result:
Lender A has a lower APR (6.08% vs 6.20%) because it charges lower fees.
Interpretation:
Even with identical interest rates, APR reveals the true cost difference. However, if you'll refinance or move within 3-5 years, the upfront fee difference matters less than the APR suggests. Always calculate break-even: how long until the lower APR offsets the higher fees?
Edge Cases & Special Situations
Short-term loans
For loans you'll pay off early (e.g., auto loans you'll trade in after 2 years), APR overstates the impact of upfront fees. Focus on interest rate and total fees separately.
Variable rate loans
APR for adjustable-rate mortgages (ARMs) assumes the initial rate lasts the full term, which is rarely true. The APR is only accurate if rates stay constant.
Credit cards
Credit card APR is usually just the interest rate (no fees included). But promotional APRs (0% for 12 months) can be misleading—check what the rate jumps to after the promo period.
Refinancing
When refinancing, compare the new APR to your current interest rate (not your old APR), since you've already paid the old loan's fees.
Key Takeaways
APR is a powerful comparison tool, but it's not perfect. Use it to compare similar loans with similar terms, but always read the fine print to see what's included. For long-term loans you'll hold to maturity, APR is the best metric. For short-term loans or if you'll pay off early, focus on interest rate and fees separately. Remember: the lowest APR isn't always the best deal if it comes with restrictive terms, prepayment penalties, or if your situation doesn't match the APR's assumptions.