Definition
The true cost of a loan is measured by the annual percentage rate, or APR. This is the annualized cost of a loan, which not only takes into consideration the interest charges on the loan's principal, but also application fees, points, and insurance.
The Federal Truth in Lending Act requires financing and other lending institutions, to provide the consumer with the annual percentage rate on mortgages, car and personal loans, and credit card balances.
Calculation
The annual percentage rate helps the consumer determine the impact that other expenses, such as fees, have on the total cost of the loan. A simplified formula for APR takes the following form:
Annual Percentage Rate = Interest Rate on Loan + Loan Fees
Explanation
The APR allows consumers to make fair comparisons of loans between institutions, or within an institution. The lower the APR, the lower is the total cost of the loan to the consumer. This value is not used to calculate the monthly payment on a loan. The loan's principal, interest rate, and term (or length) are the only factors required to calculate monthly payments.
Example
A 30 year home loan in the amount of $100,000, was advertised with an interest rate of 6.000%. This loan requires the payment of 2.0 points and $1,200 in processing and various loan origination fees. In this example, the APR on this loan was determined to be 6.296%. Note: The above calculation was performed using our Mortgage APR Calculator.
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