Whenever I wished to compare loan quotes, I was always baffled by the confusing financial jargon, like APR, interest rate, points, closing costs, etc. Till I started my full-fledged finance studies, I always thought that annual percentage rates and interest rates were one and the same thing, just results of different calculation methods. Now, I know that such is not the case. This article should help you in understanding the difference between the two financial terms as well as the annual percentage rate formula.
Simple Mortgage Interest Rates
Interest rate is a simple percentage figure, that stands as the basic borrowing cost on the principal borrowed. The interest amount is a direct percentage of the actual amount of borrowed funds. In other words, it is the rent compensation paid by the borrower to the lender to compensate for his opportunity cost of lending you that money, as opposed to investing it elsewhere. Interest rates are usually the ones taken into account when making initial comparisons between various loans, as they directly affect the monthly payments of the borrower, something that most debtors are most concerned with.
Though low interest rates are the first thing that people look for when hunting for good deals on loans, these rates are usually not the only monthly expense that goes towards the loans. As there is usually a trade-off between interest rates and other upfront costs of acquiring the loan, i.e., lower the interest rates, higher the associated costs and vice versa, just hunting for a low interest rate deal is not always the most beneficial option. This is where the APR comes into the picture.
Annual Percentage Rate
The best way to explain the term to a layman, is to say that it represents the 'true cost of his loan'. The basic difference between the two happens to be just this - while the interest rate is just the intrinsic borrowing cost, calculated as a percentage of the loan amount, the APR includes the other associated loan expenses that usually cannot be seen from the actual interest rate figures. In simple terms, it is nothing but another representation of the effective rate of interest that the borrower will be burdened with, and so, it is always higher than the normal interest rate.
Theoretically, all fees required to finance the loan are incorporated into the calculation of APR, but as different lenders incorporate different fees and leave out different ones, not all lenders with similar loan terms and conditions reach to the same rate. Either way, whatever the expenses to be taken into account, the calculation requires that all such amounts be totaled and amortized over the entire loan period. The new rate calculated after included all such additional payments into the interest rate calculation is what is known as an APR.
While this rate covers all the drawbacks of the normal mortgage interest rates, it also has a few limitations of its own. For one thing (as already mentioned earlier), as there are now clear rules as to which expenses to include and which to leave out in the calculation, most lenders choose the expenses to suit their ends.
Expenses, which are usually not considered in the formula are home appraisal expenses (home loans), title fees, and credit reporting fees. It is always better to ask your lender for a disclosure of expenses included and excluded in the calculation. Secondly, this method does not work well for adjustable rate loans, as all calculations are usually based on future interest rate forecasts, which may not be so accurate.
Last but not the least, since it amortizes all associated expenses as well as the original interest payments over the entire life of the loan, the only way such a deal is profitable is when the loan is actually held all the way to maturity. For example, if you have a plan in mind to settle a loan of 10 years in 5 years itself, looking for a low interest rate may be viable in your case. If you plan to refinance or retire your loan early, higher up front cost may actually turn out to be a bad deal for you, as these will unnecessarily be amortized over the entire loan period.
Difference with Interest Rate
- 'Truth in Lending Act', a federal law requires that both, the APR and the interest rates, be simultaneously disclosed to the borrowers, to protect them in credit transactions through a full and fair disclosure.
- In financial terminology, while the interest rate is just the 'pure cost of money', APR includes all additional costs that make it the 'true cost of money'.
- While traditional interest rates exclude transaction costs and other fees in their calculations, this term includes most of them. This makes it a better indicator of how much the borrower is actually ending up paying to the lender, in compensation for his loan.
- Because of the inclusion of additional costs, the APR is always higher than the nominal mortgage interest rates.
- Loan comparisons using this annual rate are more accurate than comparisons made on interest rates, for a low interest rate loan usually has higher other associated costs and vice versa.
- Judging a book (loan) only by its cover is also not a prudent strategy, as this rate analysis does not reveal things like balloon payments, prepayment penalties, and rate lock-in periods.
Hope this information helps you make wise loan decisions. Remember, always be prudent when raising large amounts of debt.
Disclaimer: This article is for reference purposes only and does not directly recommend any specific financial course of action.