Interest rates and Annual Percentage Rates (APR) are two terms that are very similar but have subtle differences when it comes to calculation. When evaluating the cost of a loan or line of credit, it is important to understand the difference between the two. We break it down here.
What Is An Interest Rate?
An interest rate refers to the annual cost of a loan to a borrower expressed as a percentage.
The advertised rate, or nominal interest rate, is used when calculating the interest expense on your loan. If you are considering a mortgage loan for $200,000 with a 6% interest rate, your annual interest expense would come out to $12,000, or $1,000 per month.
Interest rates can be affected by the federal funds rate set by the Federal Reserve. The federal funds rate is the rate that banks lend reserve balances to other banks. Based on the current state of the economy and whether there is strong economic growth or a recession at the time, the rates may change.
What is An APR?
An Annual Percentage Rate (APR) is the annual cost of a loan to a borrower — including fees. Like an interest rate, the APR is expressed as a percentage. However, the APR also includes other charges or fees such as mortgage insurance, closing costs, discount points, and loan origination fees.
When comparing loans, the APR is the better rate to consider because it not only includes the interest expense on the loan, but it also includes all fees and other costs involved in securing the loan. These fees can also include broker fees, rebates, or discount points. The APR should always be greater than or equal to the nominal interest rate, except in the case of a specialized deal where a lender is offering a rebate on a portion of your interest expense.
If you decide to focus on the APR, you need to be mindful that the lender servicing costs included in the APR are spread out across the entire life of the loan and can make refinancing or selling your home more expensive than originally suggested by the APR. The APR is also not the best at capturing the true costs of an adjustable-rate mortgage, since predicting the future direction of interest rates is impossible.
The Summary
Although the interest rate determines the cost of borrowing money, the APR is a more accurate depiction of total borrowing cost because it takes into consideration other costs associated with getting a loan. When determining which loan provider to borrow money from, you will need to pay attention to the APR, meaning the real cost of financing. The APR is intended to give you more information about what you’re really paying.
The Federal Truth in Lending Act requires that every consumer loan agreement disclose the APR. All lenders must follow the same rules to ensure the accuracy of the APR, which makes the APR a good basis for comparing certain costs of loans.
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