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 a 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.
Put simply, a loan’s interest rate is what you pay to the lender for borrowing money. The APR is a measure of the interest rate plus the other fees charged with many types of loans, or the effective rate of interest. Both are expressed as a percentage.
Interest Rate
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 $1,000 a month through the year. Interest rates can be influenced by the federal funds rates 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 typically will 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, less spending, and to balance out cash flow.
APR
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 go $5,000. 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%.
While the interest rate determines the cost of borrowing money, the annual percentage rate (APR) is a more accurate picture of total borrowing cost because it takes into consideration other expenses 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.