Understanding What Annual Percentage Rate (APR) Means, Is, and What It Is Good For

We all know that when you go to get a loan there are so many acronyms thrown at you that it is difficult to understand what in the world anyone is saying. One of the key things we hear on TV and the radio is APR. What is APR, what does it mean to me? Why do so many companies tout it as the be all and end all? The first thing to understand when looking at your annual percentage rate or APR is that this is not your interest rate. They are 2 very different things. Your APR will actually measure the total cost of your loan. Whereas your interest rate is what you will be actually paying monthly on your loan.

When you look at your good faith estimate there are boxes marked called PFC's or pre paid finance charges. They encompass everything from inspection, origination, and appraisal all of these are included and then spread out over the time of the loan usually 15-30 years, this is your APR. They are included weather you pay them or the builder, lender, or third party pays them at closing. At the end of the day the builder/lender may pay these for you but the APR does not account for any of that.

The APR is just stateing that this will be the total cost of your loan. Better said, over the time of the loan this is what you will pay out total. Again the lender/builder etc may pay part or most of these at closing, but the bank has no way of acknowledging that someone else paid that at closing it is just a part of the total of cost of doing the loan.

The book definition of APR is- A uniform measurement of the cost of a loan including interest and finance cost of closing, expressed as a yearly interest rate.

It is not a good idea to compare lenders based on APR's, you want to compare good faith estimates. The good faith estimate will let you know where the fees are being allocated and what charges are being assessed. For example an attorney fee maybe listed at $300-600, the good faith estimate showing an estimated fee of $600 would have a higher APR but the actual cost may only be $400 and this maybe paid by a third party at closing.

The good faith estimate will break down each charge so you can see where the difference in the APR is coming from. You don't want to just look at the total APR rate, because you may be able to alter it using different suppliers for the things needed on the good faith estimate. For example a lender with a lower interest rate may highball the good faith estimate, while a lender with a higher interest rate may lowball the good faith. Meaning that the lower interest rate would be a better fit even though the APR may look higher because the actual costs may not be as high as they projected.

The interest rate is what you will be paying each month on your loan. Not the APR. The APR is usually a point to a point and a half higher than your interest rate. The primary question that comes to mind then is why would I have 2 different rates? My interest rate and the APR?

The APR will take into account the cost of getting the loan, such as origination, attorney fees, etc it does not take into account whether these fees are paid at closing by you or a third party, just that they are part of the loan. Hence the total will be higher, for example if you have $5000 in closing costs the APR takes this over the course of the life of the loan where as your interest rate and your actual payment does not.

The point of an APR used to be if you were comparing companies 1-2-3 all with the same interest rate then the one with the higher APR usually had more fees. In today's market since not every bank includes the same fees or rates for the fees with the APR, what you want to be concerned with is the interest rate and the good faith estimate not the APR.

So in summary, don't focus on the APR as much as the good faith estimates from each lender to see what fees are actually being assessed. This way you are not fooled by advertisements saying 0% APR, all these are saying is that they are not going to include certain critera that the APR looks at. You want to look at the overall cost, they may advertise it as 0% APR, but that does not mean that you have a 0% interest rate!