A:

When evaluating the cost of a loan or line of credit, it's important to understand the difference between the advertised interest rate and the annual percentage rate, or APR. The advertised rate, or nominal interest rate, is used when calculating the interest expense on your loan. For example, if you were considering a mortgage loan for $200,000 with a 6% interest rate, your annual interest expense would amount to $12,000, or a monthly payment of $1,000. The APR, however, is the more effective rate to consider when comparing loans. Expressed as a percentage, the APR includes not only the interest expense on the loan but also all fees and other costs involved in procuring the loan.

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. Returning to the example above, consider the fact that your home purchase also requires closing costs, mortgage insurance and loan origination fees in the amount of $5,000. In order to determine your mortgage loan's APR, these fees are added to the original loan amount to create a new loan amount of $205,000. The 6% interest rate is then used to calculate a new annual payment of $12,300. To calculate the APR, simply divide the annual payment of $12,300 by the original loan amount of $200,000 to get 6.15%.

When comparing two loans, the lender offering the lowest nominal rate is likely to offer the best value, since the bulk of the loan amount is financed at a lower rate. The scenario most confusing to borrowers is when two lenders are offering the same nominal rate and monthly payments but different APRs. In a case like this, the lender with the lower APR is requiring fewer upfront fees and offering the better deal.

The use of the APR comes with a few caveats. Since the lender servicing costs included in the APR are spread out across the entire life of the loan, sometimes as long as 30 years, refinancing or selling your home may make your mortgage more expensive than originally suggested by the APR. Another limitation is the APR's lack of effectiveness in capturing the true costs of an adjustable rate mortgage, since it’s impossible to predict the future direction of interest rates.

The Federal Truth in Lending Act requires that every consumer loan agreement list the APR along with the nominal interest rate. The fact that all lenders must follow the same rules to ensure the accuracy of the APR creates a more level playing field for borrowers and a much more effective means of determining the true cost of a loan.

RELATED FAQS
  1. What are the differences between APR in Europe and the U.S.?

    Learn how the regulatory authorities in the U.S., the European Union and the U.K. treat the calculation and disclosure of ... Read Answer >>
  2. Are APRs different in different countries?

    Learn about the term APR and how it is used in the United States and other countries. Explore why different lenders charge ... Read Answer >>
Related Articles
  1. Investing

    The Interest Rates: APR, APY And EAR

    When most people shop for financial products, all they focus on is the listed interest rate. Human eyes instinctively dismiss the fine print, which usually includes the terms APR (annual percentage ...
  2. Personal Finance

    States That Allow Car Title Loans

    Only some states permit car title loans – and those that do may have restrictions. Check this list to see what to expect.
  3. Small Business

    Swift Capital Review: Safe for a Business to Use?

    In this Swift Capital review, find out how these short-term operating loans work for small businesses – and whether they're a good deal.
  4. Personal Finance

    Lending From A Loan Officer's Perspective

    Learn how a loan officer thinks, so that you can get the best and safest loan.
  5. Managing Wealth

    Unsecured Personal Loans: 8 Sneaky Traps

    If you are seeking a personal loan, be aware of these pitfalls before you proceed.
  6. Tech

    Good Credit? Try This Credit Card Alternative

    Personal loans are a credit card alternative to try if you've got great credit and you want to lock in a lower interest rate on what you borrow. [underlined word is credit card alternative]
  7. Personal Finance

    How to Find the Best Refinance Companies

    From traditional lenders to online loans, here's everything you need to know about refinancing your mortgage.
  8. Personal Finance

    How To Read Loan And Credit Card Agreements

    The devil is always in the details! Find out what you're signing yourself up for.
  9. Investing

    Home-Equity Loans: A How-To Guide

    Looking for a home-equity loan? The rules are the same as for any other purchase: First, educate yourself, then shop for the best deal.
  10. Personal Finance

    APR and APY: Why Your Bank Hopes You Can't Tell The Difference

    Banks use these rates to entice borrowers and investors. Find out what you're really getting.
RELATED TERMS
  1. Annual Percentage Rate - APR

    The annual rate that is charged for borrowing (or made by investing), ...
  2. Purchase APR

    The annual percentage rate that applies to outstanding balances ...
  3. Loan

    The act of giving money, property or other material goods to ...
  4. Origination Fee

    An up-front fee charged by a lender for processing a new loan ...
  5. Temporary Lender

    A mortgage lender that sells the loans it originates into the ...
  6. Total Annual Loan Cost (TALC)

    The projected total cost that a reverse mortgage holder should ...
Trading Center