What is an Annual Percentage Rate?

Tricia Christensen
Tricia Christensen

When you take out a mortgage or a large loan, you are often told what your annual percentage rate (APR) will be. It’s especially important to know this, since the APR can differ significantly from the percentage rate the company advertises. Many countries, including the US and Canada require lenders to state the APR so that consumers can make informed choices about the amount of interest they can reasonably expect to pay.

Credit cards calculate interest based on an annual percentage rate.
Credit cards calculate interest based on an annual percentage rate.

The annual percentage rate on a mortgage doesn’t just include interest and compound interest, but it also includes other costs. Generally, fees like points, loan fees, closing costs, and loan origination fees will be included. The APR may also include the cost of mortgage or life insurance, any fees charged by attorneys or notaries, and fees charged for applying for a loan.

One of the things you’ll generally see included in the annual percentage rate is the amount of interest you might prepay. For instance, some loans are scaled so that when you begin making payments, more of the loan is first applied to interest than it is to the principal. Over time, your payments pay more to the principal and less interest, but if you’re paying a significant amount of interest in the beginning, this must be included in the APR.

When you have credit card loans the annual percentage rate is an estimate and not an actual figure. This type of loan allows you to borrow money again once you’ve paid it off, and is better figured by judging the effective annual rate. If you repeatedly borrow money, your interest, which is compounded monthly, is going to gradually increase the total amount of money you owe. Credit card companies may not include penalties from late payments or exceeding the limit of your loan in the effective annual rate or the APR.

You should not use only the annual percentage rate to judge the quality of any type of loan. It’s a good first step comparison between different lenders, but it won’t completely represent the cost of borrowing money. It can leave out some important fees, and a lower APR can sometimes be correlated with paying more than the value of something you purchase. You might get a bad deal when you buy a house that seems good because the annual percentage rate on the house is lower. In reality, you’re making up for the lower APR by paying more for the house than you should.

It is very important to evaluate certain types of loans for annual percentage rate that are interest only loans. These loans require you to pay back the interest on the home prior to ever paying any part of the principal. Since you haven’t made a dent in the original loan, you will pay considerably more by using an interest only loan, because you will keep getting charged interest on a principal that remains the same. When you can, take a loan or mortgage that allows you to pay part of the principal. The amount of interest you pay will decline as you pay part of the money you owe each month, resulting in less overall money paid out to pay back the loan.

Tricia Christensen
Tricia Christensen

Tricia has a Literature degree from Sonoma State University and has been a frequent wiseGEEK contributor for many years. She is especially passionate about reading and writing, although her other interests include medicine, art, film, history, politics, ethics, and religion. Tricia lives in Northern California and is currently working on her first novel.

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