Interest rates and APR are two frequently conflated terms that refer to similar concepts 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 advertised interest rate and the annual percentage rate (APR), which includes any additional costs or fees.
- The interest rate is the cost of borrowing the principal.
- The APR is almost always higher than the interest rate, including other costs associated with borrowing the money.
- The federal Truth in Lending Act requires that every consumer loan agreement list the APR along with the nominal interest rate.
- Lenders must follow the same rules to ensure the accuracy of the 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.
Interest rates can be influenced by the federal funds rate set by the Federal Reserve, also known as the Fed. In this context, the federal funds rate is the rate at which banks lend reserve balances to other banks overnight. For example, during an economic recession, the Fed will typically slash the federal funds rate to encourage consumers to spend money.
During periods of strong economic growth, the opposite will happen: the Federal Reserve will typically raise interest rates over time to encourage more savings and balance out cash flow.
In the past few years, the Fed changed interest rates relatively rarely, anywhere from one to four times a year. However, back in the recession of 2008, rates were gradually decreased seven times to adjust to market conditions. While not determinant of mortgage or other interest rates, it does have a big influence reflecting larger market conditions.
The APR, however, is the more effective rate to consider when comparing loans. The APR includes not only the interest expense on the loan but also all fees and other costs involved in procuring the loan. These fees can include broker fees, closing costs, rebates, and discount points. These are often expressed as a percentage. 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 a 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 is impossible to predict the future direction of interest rates.
The Bottom Line
While the interest rate determines the cost of borrowing money, the APR is a more accurate picture of total borrowing cost because it takes into consideration other costs associated with procuring a loan, particularly a mortgage. When determining which loan provider to borrow money from, it is crucial to pay attention to the APR, meaning the real cost of financing.