When purchasing a home, we often discuss the terms APR & Interest Rate. But people are sometimes confused about the differences in the annual interest rate, which determines the payment for the loan, and APR, which includes the total costs of obtaining the loan.

APR is a measure of the cost of credit, expressed as a nominal yearly rate. It is the equivalent interest rate (considering all additional costs) charged on a certain loan amount. In short we can say that, APR = Interest rate + Extra cost

The additional costs associated with calculating APR vary from one lender to another. In reality, it includes any cost that is financed into the loan and may include discount points, loan origination fees, mortgage insurance premium, etc.

I know it’s difficult to believe, but some lenders often mislead borrowers by charging hidden fees. This is where the APR can be of help. It is used to compare the true cost of various loans and find out whether the creditor has included any hidden fees.

In 1968, in an effort to protect consumers from the tricks of lenders and clear their doubts on terms related to credit and rates, the FDIC enacted the Truth in Lending Law. Regulation Z, Part 226 of the Truth in lending Act came into effect from July1, 1969. This section defines the Annual Percentage Rate (APR) and requires creditors to disclose the APR to a borrower within three days of receipt of loan application. Now that we’re no longer confused, let’s look at a simplified example:

1. If you borrow $100,000 for 30 years at 7%, your payment (principle and interest) will be $665.30.
2. Assume, however, that $1,000 of this amount was added into the loan to cover financing costs. Without these added costs, you would only have had to borrow $99,000.
3. The payment on $99,000 at 7% is $658.65
4. A payment of $665.30 (which is your actual payment), on a loan of $99,000 (the amount you should have had to borrow), coincides with an interest rate of 7.1%, which is you APR.

Try it for yourself. In Microsoft Excel, follow these steps:

To find the monthly payment for loan including the closing costs, enter the following formula;

=PMT(0.07/12,360,100000)

.07 divided by 12 is the monthly interest rate (you’re using a monthly rate to find monthly payments)
360 is the number of payments (30 years X 12 months = 360)
100,000 is the present value of your loan (including the additional costs)

You should have a result of $665.30.

Next, Solve for the APR by entering the following formula:

=RATE(360,-665.30,99000)

360 is the number of periods you pay on the loan (360 months or 30 years)
- 671.96 is your payment
99,000 is the present value of your loan (how much you’re actually borrowing)
You should have a result of .592%. This is a monthly rate. Multiply by 12 to get 7.0999%.