What is an annual percentage rate?

The annual percentage rate (APR) represents the average annual finance charge you would be paying on a loan when considering all the fees and loan costs divided by the total amount borrowed. The APR on a loan is a valuable number for you to know so you can compare directly the total costs of loans that might have widely varying terms. For example, if you've been offered a 30-year fixed-rate mortgage at seven percent with one point, and a 15-year fixed-rate mortgage at six percent with one and half points -- how do you know which is really the better deal for you?

Here is an example to give you an idea what the APR on a loan can tell you:

Pretend you want to borrow $10,000 and have two loan options. Both are 30-year loans; one has an interest rate of seven percent and the other has an interest rate of seven percent with one point. You might think the decision is easy. However, loans have a nasty habit of having all sorts of fees and hidden terms in the fine print, such as origination fees, application fees, closing fees, and processing fees. The APR will consider all these other costs and points when being calculated. This is why the APR will give you the most accurate means of comparing two loans.

So with the $100,000 loan example, you'll be paying $665.30 per month on either loan. However, once you add up the point paid on one loan upfront ($1,000) and a range of fees (say, another $1,025), the APR will take the total of those payments ($2,025) and deduct that from the total loan amount ($100,000 - $2,025 = $97,975). Now, if you're paying the same $665.30 a month, but on a loan of $97,975, you're really paying an interest rate of 7.2 percent. Looking at the APRs for each loan will reflect this difference.

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