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APR vs. Interest Rate: What Do They Really Mean?

Shopping for a loan? Whether it’s for a car, house, or a life-size replica of that thing from Alien, you’ll see the same three letters pop up in every ad with a rate — APR. 

So what does this mysterious acronym (standing for “annual percentage rate”) actually mean when it comes to how much you’re paying for your loan? While many people think it’s the same as an interest rate, that’s not quite right. And knowing the difference can save you money when you decide to take out a loan.

 

What’s the difference between APR and interest rate?

 

An interest rate is the annual cost of a principal loan amount expressed as a percentage. Simply put, it is the amount a lender charges you to finance your purchase. It can be variable or fixed. Because the interest rate drives the monthly payment, it will give you a good understanding of how much you can expect to pay monthly. 

The APR is similar to the interest rate, but it includes something that megabanks have a bad habit of trying to hide in the fine print — fees. The APR is usually a higher amount than the interest rate and provides the overall estimate of the loan cost. So you can think of it as the total cost of getting a loan or mortgage. Here’s what it includes: 

  • Broker fees

  • Loan orientation fees 

  • Mortgage insurance

  • Closing costs

  • Discount points

How are APRs and interest rates calculated?

 

Lenders calculate the interest rate and APR, but it’s handy to know how they crunch the numbers to make sure you’re getting a good deal.

The interest rate takes into account the current interest rates (which is based on economic conditions) and your credit score. Borrowers who have a higher credit score will have a lower interest rate. 

When the lender determines the APR of your loan, they take the interest rate and add any additional fees to the amount — so the APR can vary dramatically between lenders.

According to the Federal Truth in Lending Act, lenders must disclose the APR in every consumer loan agreement. However, lenders are not required to include some costs, such as credit reporting and inspection fees. Be sure to ask your lender what is and is not included in the advertised APR so you can make the most informed decision possible. 

 

What matters most when selecting a loan?

 

Choosing a loan based on the APR or interest rate comes down to your loan type, budget, and priorities. If the most important thing to you is having the lowest monthly payment, finding the lowest interest rate will help you do that. However, you may end up paying more for the loan overall when you factor in the APR.

Because the APR is a more comprehensive amount, it’s best to use it to compare the cost of loans from different institutions. Comparing the APR will give you the best understanding of the total loan cost.

If you’re buying a house, your selection process might be a little different, depending on your term. Seeking a long-term mortgage? Be strategic about selecting the lowest APR for your mortgage. If you plan to stay in the home for a long time, having a lower APR means you will end up paying a lower amount overall to finance your home. 

Looking to purchase a home and live in it short-term? Choosing a higher interest rate and APR in exchange for less upfront fees could be your best bet. Before you choose an APR, you should determine the break-even point for your APR. Calculating these numbers can be difficult, so it’s wise to work with an expert who knows the industry (i.e. a lender at your local community bank or credit union!). 

Moral of the story: perform your due diligence before selecting a loan or mortgage. Comparison shopping can take time, but it could also save you a lot of money down the road — and that’s worth an extra Google search or branch visit. 

Tags: Dollars & Cents, Home Ownership