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.