May 9th, 2009 12:49 PM by Don Groff, Mortgage Broker
By Don Groff
This question comes up a lot when I am working with my clients and we are discussing their loans. In this Blog I will help explain the difference between interest rate and APR (Annual Percentage Rate). To break it down, the interest rate is the percentage you pay on your loan amount financed. Although APR is quoted as an interest rate it is actually a way for borrowers to compare fees associated with the mortgage loan. Two identical loans with the same interest rate may have different APR’s. That is because of the fees involved with that loan. All things being equal, the higher the APR the higher the fees involved. Below I will explain in greater detail because a higher APR does not necessarily mean the loan is a better fit for your situation. As with everything in life there are tradeoffs.
Let’s start with some definitions:
What is the interest rate?The interest rate is the percentage of the loan amount that is charged for borrowing money. We can consider this the base fee. It is very important when comparing loan quotes since it directly affects monthly payments.
What is the APR (Annual Percentage Rate)?The APR is a little more complex and is comprised of two factors: it includes your actual interest rate and any additional costs. Additional costs might include things like prepaid interest, private mortgage insurance or closing fees. Your APR represents the total cost of credit on a yearly basis after all charges are taken into consideration. It is typically higher than your actual interest rate because it includes these additional items and assumes you will keep the loan to for the full term.
How APR is calculated?
To calculate the APR, the lender fees (fees required to finance the loan) are incorporated into the interest rate. This is done by amortizing the fees out over the life of the loan as if they were additional payments, and then calculating a new rate.
Limitations of APRAs useful as the APR can be, it has its limitations. APR spreads the fees paid upfront over the life of the loan. So the comparison of APR is only accurate if you plan to keep the mortgage for the entire length of the loan. Since most borrowers do not keep their loan for the full period (they typically refinance or move), the APR can make some loans look artificially better. In the example above, if you only kept the loan for 3 years, the second loan would be much more expensive even though it has a lower APR. This is because the $6,000 in fees is paid upfront whereas the higher interest rate in the first loan is amortized over the life of the loan.
The other problem with APR calculations is that different lenders may include different fees in their APR calculations for various loan programs. Remember to always ask your lender what is included and not included in your APR.
Don Groff has over 8 years of experience in the mortgage lending and real estate fields. His key areas of expertise are in residential mortgage lending and loan structuring to best suit his client’s needs and objectives.