APR is not your interest rate. APR is a number that shows how much a loan will actually cost you, because it includes fees and other costs in addition to interest. You can calculate it with a formula.
How to calculate APR?
APR = [(Total interest paid + fees) ÷ (Loan amount × Loan term in years)] × 100
For better understanding, look at this example:
- Loan amount: $100,000
- Interest rate: 5%
- Loan term: 30 years
- Closing costs: $3,000
Step 1: Find your monthly payment
using the loan amount, interest rate, and repayment term, your monthly payment (Principal + Interest) would be about $537.
Step 2: Calculate the total cost of the loan:
Multiply the monthly payment by the total number of payments, then add the fees and costs.
Total Cost = ($537 × 360) + $3,000 = $199,320
Step 3: Separate the Interest Amount
Total Interest = $199,320 − $100,000 = $96,320
Step 4: Plug the Numbers into the Formula
APR = [(96,320 + 3,000) ÷ (100,000 × 30)] × 100 ≈ 3.31%
This is a simple, back-of-the-envelope calculation. When a lender provides an APR on a Loan Estimate, Regulation Z, which governs how annual percentage rates are reported for mortgages, requires them to use a more accurate method of calculation.
The above formula is good for roughly comparing different loan offers, but the number on your official loan documents is the one that matters legally.
APR vs. Interest Rate: What’s Actually Different
|
Feature |
Interest Rate |
APR |
|
What does it show? |
The cost of borrowing the loan principal |
The overall cost of the loan including interest and fees |
|
Includes fees? |
No |
Yes |
|
Used to calculate monthly principal and interest payments? |
Yes |
No |
|
Includes origination fees, broker fees, and discount points? |
No |
Yes |
|
Which one is usually higher? |
Lower |
Slightly higher |
|
Best for comparing loan offers? |
Limited |
Better comparison tool |
The interest rate is the cost you pay to borrow the principal amount of a loan, excluding any other fees. It is the number used to calculate the monthly payment of principal and interest on a loan.
APR (Annual Percentage Rate) is a broader term. It combines the interest rate with additional fees, such as origination fees, broker fees, discount points, and most closing costs, and then shows the total cost of the loan as a percentage per year.
That’s why the APR is usually slightly higher than the stated interest rate.
It’s also why comparing two loans based on interest rates alone can be misleading. A loan with a lower interest rate but higher fees and charges may have a higher APR than a loan with a slightly higher interest rate and fewer fees.
What costs are included when calculating the APR?
Note that not all costs associated with a mortgage are included in the APR. These costs include:
- Interest Rate: The basic cost you pay to borrow the principal amount of the loan.
- Origination Fees: The fee the lender charges to review, process, and approve the loan.
- Broker Fees: This fee is charged if a broker processes the loan on your behalf.
- Discount Points: A fee you pay up front to reduce the interest rate on the loan.
- Certain Closing Costs: Costs such as appraisal and underwriting are usually included in the APR; But costs like Title Insurance and Recording Fees are usually not included, as these are paid to third parties and exist regardless of which lender you choose.
- Mortgage Insurance: When mortgage insurance is required because the down payment is below a certain limit.
Example, Calculating the APR for a DSCR Investment Loan
Here’s an example to help you better understand the calculation.
Let’s say you’re looking to buy a rental property and you’re taking out a DSCR loan. With this type of loan, your eligibility is based on the rental income from the property, not your personal income from your W-2.
Loan Amount: $250,000
Interest Rate: 7.5%
Loan Term: 30 Years
Termination Fees: $6,000
Your monthly principal and interest payment will be about $1,748.
Over 360 monthly payments, the total payments are:
1,748 × 360 = $629,280
Adding $6,000 in upfront costs:
Total loan cost = $635,280
Then we subtract the principal amount of the loan:
635,280 − 250,000 = $385,280
This number includes the total interest and loan fees. Plugging it into the formula, the simplified APR is approximately:
5.1%.
Note that there is a difference between the stated loan rate (7.5%) and this lower APR number. This is because this simplified formula divides the total finance charge annually over the entire loan amount and term, while lenders’ software does a more precise calculation and takes into account the effect of compounding interest monthly.
However, this method is still useful for determining which of two loan offers is actually cheaper, as the same calculation is performed for both offers in the same way.
For DSCR investors, this is even more important because fee and cost structures can vary greatly between different lenders. A loan with a slightly higher interest rate but fewer points and fees may be a better option after factoring in the APR than one with a lower rate but higher fees.
Conventional Loan APR and the Mortgage Process
Understanding how conventional loans work is important because APRs can look different depending on the type of loan.
Conventional loans, which are not insured or guaranteed by the federal government, typically combine the interest rate along with any additional fees and charges into a single APR number. This makes it easier to compare them to other options, such as government loans or DSCR loans.
The APR is first formally displayed during the mortgage acquisition process, on the Loan Estimate form long before you commit to a loan or lock in your rate. This is where you can compare different loan offers.
Common Mistakes When Calculating APR
There are some common mistakes that you should definitely avoid:
Ignoring Fees
This is the most common mistake. If you just include the interest rate in your calculations and exclude fees like loan origination fees or broker fees, you haven’t actually calculated the APR; you’ve just restated the interest rate in a more complicated way.
Ignoring the Loan Term
A longer loan term means that the fees are spread over a larger number of payments, which changes the APR, even if the interest rate and the amount of fees are exactly the same. When comparing two loans, you should always keep the loan term constant.
Assuming that a lower interest rate always means a lower APR
This is not true.
For example, a loan with a 6.5% interest rate and $8,000 in fees may have a higher APR than a loan with a 6.9% interest rate and only $1,500 in fees, especially on shorter term loans.
Ignoring Compounding Frequency
The number of times interest is calculated and compounded affects the actual cost of the loan. Always check this with the information provided by the lender and don’t assume that the calculation is done only monthly.
Why is APR more important than the interest rate you see in advertisements?
Real estate investors pay attention to APR for a few specific reasons:
- Ability to directly compare different loan offers: When two lenders offer different interest rates and fee structures, converting both to APR allows them to be compared on a level playing field.
- Direct impact on ROI calculations: A lower APR means lower financing costs, which means more room for cash flow.
- Helps you choose between different loan options, especially DSCR loans: When an investor compares Debt Service Coverage Ratio on DSCR loans to other options, APR shows whether a loan with a higher quoted rate is actually a cheaper option after all costs are taken into account.
