Understanding APR Annual Percentage Rate Calculation

by Mark Johnston

Here at mortgagerates.org.uk, we use the term APR a lot when we are talking about mortgages and loans many of us may know what it stands for which is Annual Percentage Rate, but what does it actually mean?

Most people understand the idea of interest rates. You pay back a little more than what you borrow, this tends to be a percentage of original amount. However, other expenses other than the interest rate can affect the cost of borrowing. These can be any sort of fee or charge that the borrower is required to pay such as administration charges, setup charges, acceptance fees, arrangement fees, these together with the interest rate is the real cost of borrowing. This, together with the various different ways that Lenders have for charging interest makes it hard to compare the true cost of borrowing.

In the UK mortgage lenders are required to disclose the cost of borrowing in a standardised way so we can be a little more protected as customers. Simply knowing the interest rate is not usually enough for us to compare one credit deal with another. The Total Charge for Credit regulations set out a standard way to calculate APR, this is a standard measure for borrowers to use to enable them to compare one deal against another.

There are two different ways two calculate the APR, one is called the effective APR and the other is called the nominal APR.

The nominal APR is the annual interest rate for a product. This is usually calculated by multiplying the rate for a payment period by the number of payment periods in a year. Most rates in the UK are based on an annual rate but be careful some may not be. A monthly rate of 3% would work out at 36% APR.

The effective rate on the other hand tends to be a more accurate illustration of what you will pay. This helps when you are comparing a few different rates to get the best deal such as when shopping for a mortgage. The effective rate is sometimes referred to as the EAR which stands for Effective Annual Rate. This is a slightly more complicated calculation as it not only annualises the interest rate but it also takes into account compounded interest and some fees associated with the loan.

Imagine if we were looking to take out a mortgage and found two great deals. One mortgage with a rate of 4.9% with the other slightly more at 5%. If you compared just the rates then we could assume that the 4.9% mortgage is a better deal. Now, what if the 4.9% has a booking fee of £2,499 and the 5% mortgage doesn’t, how would we know which was the best deal? Well, we’d look at the APR, the 4.9% mortgage with a booking fee of £2,499 would have 5.07 APR whilst the 5% mortgage would be a slightly better buy as the APR would only be 5%.

Next time you are looking for a mortgage remember to visit mortgagerates.org.uk and look out for the APR so you can compare different deals. We keep you up to date with the best deals and mortgage news from the UK.

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