There are many different reasons to consider applying for a loan. Whether you are hoping to make a big purchase, pay off existing debts, or otherwise improve your financial situation, applying for a loan can help give you the financial support you need.
And as you will quickly find when you look online—or even occasionally check the mail—there are many different loans and credit card offers available for you to choose from. While some of these offers might be just what you need, others will result in you paying much more than is actually necessary.
There are a few things you should consider when comparing different loan options. The repayment terms (i.e., when you will need to start paying the loan back), your expected monthly payment, your probability of qualifying, and the lender’s reputation will all be crucial. But, above all else, you will also want to take a close look at the annual percentage rate—also known as APR.
Navigating the lending industry can sometimes be confusing. But generally speaking, the APR will be the most useful metric available whenever you compare loan offers. In this article, we will discuss the most important things you need to know about the Annual Percentage Rate and answer some of the questions you are most likely to have.
What is the Annual Percentage Rate (APR)?
The Annual Percentage Rate, also known as APR, is the total cost of borrowing money. Essentially, this term describes how much your debt will grow each year until you pay it back.
As you’d probably expect, having a loan or credit card with a lower APR will almost always be a good thing (though there are some exceptions, as we’ll explain below). When applying for a loan, the APR you will qualify for will usually depend on your credit score, income, and other factors.
What are the Different Components of APR?
APR doesn’t just include the “raw” interest rate attached to the loan. It also includes all associated fees and charges, which nearly every loan or credit card has.
While the interest rate attached to the loan will make up the bulk of the APR, you should also be ready to pay some (percentage-based) fees. Usually, the term “processing fees” is used as a catch-all for any fees the bank includes when issuing the loan. If processing fees are disproportionately high, you may want to consider working with another lender.
You might also need to pay for underwriting fees, which account for the cost of originating and eventually approving the loan. Other fees you might need to pay include document fees and, in the case of getting a mortgage, appraisal fees and origination fees.
As a consumer, you have a right for your lender to explain each of these components clearly. If the lender you are currently considering is unwilling to answer your questions, it might be in your best interest to walk away and find another lender.
The extent to which these fees will apply to your particular loan depends on several factors. Originating and approving a mortgage is more complicated than a small personal loan. Other factors that might affect APR include the general state of the lending market, the benchmark rate such as Secured Overnight Financing Rate (SOFR), and whether the lender is doing any promotion. For example, when you apply for an auto loan from a dealer, they may be willing to waive some of these fees for their borrowers to feel like they are getting a good deal.
How is APR Different from the Interest Rate? Which Will Be Higher?
While the annual percentage rate accounts for every component of borrowing money, the interest rate does not.
For this reason, some people might consider the APR to represent an “interest rate plus”—APR is composed of the interest as well as every other fee that comes with borrowing. No matter what kind of loan you are considering getting, you will find that the APR is almost always higher than the interest rate.
Why Should I Care About the APR?
Anyone who is comparing multiple loans—which is something you should always do when you are thinking about borrowing any money for any reason—should care about the APR. Not all loan offers are structured the same way. At first, a prospective loan might appear to be the better option because it has a lower interest rate. However, if the fees that come with this loan end up costing more, you might needlessly give your money away if you proceed with the option.
In other words, APR is the “great equalizer” that enables consumers to compare many different loans without issue. By looking at the APR applied to every loan you are considering, you’ll have a much easier time deciding which one is right for you.
What is Compounding? Is that a Component of APR?
Though APR helps makes it much easier to compare different loan offers, it still doesn’t quite paint the full picture. Due to compounding interest, you will actually end up paying a little more for the cost of borrowing than you might initially assume.
Compounding interest occurs because your loan balance grows multiple times per year. At first, you might assume that if you have a $1,000 loan with a 10 percent annual interest rate (which we will use for simplicity’s sake), your balance will increase to $1,100 at the end of the year. But interest (usually) is applied monthly—not annually. So the “10 percent” you are paying is actually “one-twelfth of 10 percent”, or 0.83 percent, applied every month.
In the end, your balance will grow to be slightly more than $1,100—in this case, it will be $1,104.27—because the interest factor will also apply to the earlier interest payments. This is what the term compounding refers to in the finance world. And while the additional $4.27 might not seem like very much in this hypothetical example, the effects of compounding can really add up, especially when you have a larger loan or higher interest rate.
Here is the formula for APR:
A=P(1+rt), where
A=the total accumulated amount, P=the principal amount, r=the interest rate, and t=the time period
Additionally, when the loan is for a mortgage, you will be able to find the APR on the third page of the loan estimate.
So, What Does the Term “Effective APR” Actually Mean?
Ultimately, effective APR is the most useful metric for comparing loan products. Effective APR accounts for every component included in the cost of borrowing and includes the consequences of compounding interest—in other words, as the term implies, this will effectively be the total amount you end up paying over the course of the year.
When you compare the different ways of measuring the cost of borrowing, the interest rate will be the base, the APR will be the base plus all associated fees, and the effective APR will include the base, the associated fees, and the effects of compounding interest.
So, the effective APR will likely be the highest number you will see on paper. But it will also usually be the most accurate way to determine how much borrowing a certain amount of money will actually cost you.
Be sure to identify what a prospective lender means when they are using terms like “interest rate,” “APR,” or “effective APR.” While there are some mild regulations regarding how these financial institutions communicate to potential borrowers, it is still easy to get confused by the terminologies (a fact that many lenders will gladly take advantage of).
Should I Always Choose the Loan with the Lowest Effective APR?
In many situations, choosing the loan with the lowest effective APR would be the best financial decision you can make. This is especially true when comparing smaller and more straightforward types of loans, such as a credit card or personal loan from your bank.
However, there are still a few situations in which you might need to do more research, particularly when you are applying for a mortgage. Mortgages typically have closing costs of several thousand dollars (usually about 2 to 5 percent of the home’s total value), so the differences between these loans can be substantial. If a mortgage has a slightly lower interest rate but has much higher closing costs, it might make more sense to go with the higher APR option.
The Bottom Line: Be Sure to Know What You Are Borrowing
As a consumer, it is up to you to make sure you know what you are getting into every time you apply for a loan. The sometimes deceptive advertising practices within the industry have caused many people to end up paying much more than is necessary. When comparing different types of loans, the best thing you can do is look at the effective APR and every other possible cost you might need to pay.
And—we can’t stress this enough—if you have questions about a loan you are considering don’t be afraid to ask.
