When you shop for a loan, you will typically see two rates, the interest rate and the annual percentage rate (APR). If you don’t clearly understand the difference between the two, you won’t understand the difference between what you are paying in interest and the true cost of the loan. That could be the difference between a reasonably priced loan and a really expensive loan. Knowing the difference could save you hundreds or even thousands of dollars in interest costs.
Interest Rate vs. APR
Often times you will see loans advertised with a promoted interest rate, typically the lowest rate the lender currently offers. The interest rate is important, because that will determine what you pay in monthly interest costs. It could be a fixed rate or a variable rate, but it is always expressed as a percentage. To calculate your monthly interest cost, you simply take the loan amount, multiply it by the interest rate and divide it by 12. For example, a $200,000 loan with a 6% interest rate would have an annual interest expense of $12,000 and a monthly payment of $1,000.
The APR is also expressed as a percentage, but, along with the interest rate, it incorporates all of the other costs associated with the loan, including discount points and some closing costs. So, the APR calculates the real cost over the life of the loan. The APR is almost always going to be higher than the interest rates except in cases when the lender rebates a portion of the interest costs.
Comparing Red Apples and Green Apples
The confusing part is when borrowers want to compare one loan to another. If you are only interested in how much your monthly payment will be, you can compare the loans by their interest rates, making sure you are looking at the interest rate and not the APR on both loans. It is easy to determine that a loan with a 4% interest rate is going to have a lower monthly payment than a loan with a 5% rate. However, it’s possible for a loan to have a lower interest rate and a lower monthly payment, but have a higher APR. So, you could pay less interest each month but pay more in total loan costs.
If you are interested in the total costs of the loan, you would compare the APR, which is also referred to as the effective rate. This gets a little more complicated because there are many components that go into calculating the APR. Say you are looking at a $200,000 mortgage with fees and costs of $5,000. To calculate the APR, you would add the $5,000 to the loan for a total of $205,000. The total cost of the loan is then amortized over the loan term to arrive at the APR.
Because the interest rate makes up the largest component of the APR, the loan with the lower interest rate is likely to be the best value. However, where the interest rates are roughly the same, the lender offering the lower APR means there will be fewer upfront costs, which is usually the better deal. If you are considering an adjustable rate mortgage (ARM), the APR won’t be an effective comparison in true costs because the interest rate will change over the course of the loan. With an ARM, the interest rate is the best point of comparison.
The importance of the APR in comparing costs was codified in the Federal Truth in Lending Act, which requires that every consumer loan agreement include information on both the APR and the interest rate. The act requires all lenders to follow the same guidelines for coming up with an accurate APR. In essence, the APR enables borrowers to quickly compare the true costs when comparing one loan with another. One of the first documents, borrowers should study is the Federal Truth in Lending Act, which includes a full explanation of a lender’s APR and how it is calculated.
Written By: Richard Best
Writer For: Easy.Credit