What is APR (Annual Percentage Rate)?
What You Should Know
- Annual percentage rate (APR) is the total interest paid plus any fees as an annual rate.
- APR is the true cost of the borrowing as it takes into account any legal fees, appraisal fees, or origination fees on top of your interest.
- However, some fees are excluded from the APR, such as mortgage prepayment penalties and CMHC mortgage insurance premiums.
- Some lenders might try to entice borrowers with a low interest rate but high fees - using APR can allow borrowers to see how much it will really cost.
- Banks are required in Canada to provide the APR for credit products to potential borrowers.
APR vs Interest Rate
Interest is what a lender charges you in exchange for allowing you to borrow money from them. The interest rate is the interest charged as a percentage of the amount that you are borrowing, expressed in annual terms. Interest is commonly charged monthly. For example, when you make your monthly mortgage payment, a portion will go towards your mortgage principal and a portion will go towards the mortgage interest. Your interest portion is determined by your mortgage rate.
The annual percentage rate includes not just the interest charged, but also any other fees or charges from your lender. These are one-time fees that are usually paid when you apply for the loan. In the case of mortgages, the fees and charges that are included in the APR calculation include:
- Legal Fees
- Mortgage Broker Fees
- A Home Appraisal Fee and
Home Inspection Fees if required - An Origination Fee
What is not included in APR?
Charges and fees to exclude from the APR calculation:
- Mortgage Prepayment Penalties
- Optional Legal Fees for services not required by the lending bank
- Home inspection fees if not required by the lending bank
- Title Insurance
- Mortgage Default Insurance (such as CMHC Insurance premiums)
How to Calculate APR
Simple Interest APR
Use this APR formula if you are calculating the APR for a simple interest loan.
For example, let’s say that you borrowed $100 for 30 days. You were charged $2 in interest and paid a $1 fee. You pay back the entire amount borrowed ($100) at the end of the 30 days. Your APR would be calculated as:
If you calculated just your interest rate and excluded the fee charged, you would have gotten an interest rate of 24.33%. With the fee included, the APR is 36.5%.
Amortizing APR
Mortgages, personal loans, and car loans are amortized, which means that you make scheduled payments at set periods of time. Your payments are split into portions that go towards your principal balance and interest. As your principal is reduced with each payment, the portion of your payment going towards interest is also reduced, while the portion going towards your principal will increase.
When calculating the APR for an amortized loan, you will use the average principal balance outstanding for the entire life of the loan, rather than just the loan amount that you borrowed. You can estimate the average principal outstanding by dividing the original loan amount in half. The actual average would be less than half, as the interest portion of payments is larger at the beginning, while the principal portion is larger near the end of the term.
To find your actual average principal outstanding in order to manually calculate your APR, use an amortization calculator. You can also use an APR calculator to find your loan’s APR rate.
The Effect of Compounding Interest
APR does not take into account the compounding of interest. If you are concerned about the effect of compounding interest, you can use annual percentage yield (APY). While APY takes the effects of compounding into consideration, it does not take into account other fees and charges.
For most loans (with the notable exception of reverse mortgage), you are making periodic payments which prevent interest on your loan from being added to the principal. Also, lenders have a habit of charging different fees. Thus APR is often the best metric for comparing different credit products.
In the case of fixed-income investments, investors often reinvest their interest earnings. Thus compounding of interest becomes more prominent. Also, for most savings accounts and GICs, there is no fee. Therefore, APY is the appropriate measure for comparing these investments.
Why Use APR?
APR is used because it reflects your true cost of borrowing. Canada’s Bank Act requires banks to disclose the cost of borrowing when a borrower is applying for credit. This ensures that borrowers are informed about how much it will cost them and APR’s standardized calculation allows them to compare with other lenders.
Examples of APR
Example 1: Payday Loans
Cash 4 You is a payday lender that offers payday loans in Ontario. Ontario’s Payday Loans Act regulates the maximum cost of borrowing for payday loans. Cash 4 You charges $15 for every $100 borrowed. While most payday loans must be paid back in 2-4 weeks, the maximum allowed term in Ontario is 62 days.
If you borrowed $100 for 62 days, your APR would be 88.3%.
Example 2: Credit Card Balance Transfer Offers
Many credit cards in Canada offer promotional or introductory rates for new applicants. The Tangerine Money-Back Credit Card offers a balance transfer promotional offer rate of 1.95% for 6 months, with a 1% balance transfer fee.
If you transferred over and borrowed $1,000 during the promotional period only, you would be charged an initial balance transfer fee of $10. The promo rate of 1.95% is stated as an annual rate.
To simplify, assume that only interest payments are made. The interest over six months would be $9.75 (from (1.95%/2) x $1000)).
The APR including the balance transfer fee would be 3.95%.
Example 3: Effects of Time on a Mortgage APR
The longer the term of your loan, the more time there is for your fixed costs to be spread out over. For example, a home appraisal would cost the same whether you are looking to get a mortgage with a one-year term or a five-year term.
Private mortgages have short term lengths and private mortgage lenders private mortgage lenders often charge significant fees. To see how APR is affected by the duration of your loan, let’s look at a six-month private mortgage and a two-year private mortgage. If there are the same fees charged, such as lender fees, broker fees, and appraisal fees, then the six-month mortgage will have a higher mortgage APR compared to the two-year mortgage.
If a homeowner wanted to borrow for two years with six-month terms, they would need to renew their six-month mortgages three more times. Some private lenders may charge a renewal fee that is lower than initial lending fees, while others may charge fees just as they would for a new mortgage. In comparison, the homeowner could have paid them just once with a two-year mortgage.