APR v. Interest Rate - The Difference Explained
Banking Personal finance Interest rates Mathematical finance.
What is the difference between a mortgage interest rate and an APR?
When you think about getting the best mortgage home loan, you probably think about getting a nice, low interest rate. While a low interest rate is important for a good deal, you should also realize that there are other fees that going into a mortgage loan which may make it more expensive than the interest rate would imply.
In order to help consumers figure out the actual cost of the home loan, lenders can calculate the APR or annual percentage rate of the mortgage.
In fact, they are required by law to post this helpful number next to the base interest rate of the loan. As mentioned the interest rate on your home loan is the fee the lender charges you for being able to borrow money for a certain period of time.
As much as that amount is there are still other mortgage charges and fees that make the loan even more costly. That is where the APR comes in. The annual percentage rate is designed to take into account the total cost of the loan by figuring in not only the base interest rate, but also the closing costs, points, and other fees.
Unlike an interest rate, however, it includes other charges or fees such as mortgage insurance, most closing costs, discount points and loan origination fees. The APR is intended to give you more information about what you're really paying. Compare one loan's APR against another loan's APR to get a fair comparison of total cost — and be sure to compare actual interest rates, too. Get a call back from one of our lending specialists. We ask for your ZIP code because we need to know your time zone so we can call you during the appropriate business hours.
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While the difference between APR and EAR may seem trivial, because of the exponential nature of interest these small differences can have a large effect over the life of a loan. However, using an EAR of Some classes of fees are deliberately not included in the calculation of APR.
Because these fees are not included, some consumer advocates claim that the APR does not represent the total cost of borrowing. Excluded fees may include:. Lenders argue that the real estate attorney's fee, for example, is a pass-through cost, not a cost of the lending. In effect, they are arguing that the attorney's fee is a separate transaction and not a part of the loan.
Consumer advocates argue that this would be true if the customer is free to select which attorney is used. If the lender insists, however, on using a specific attorney, the cost should be looked at as a component of the total cost of doing business with that lender.
This area is made more complicated by the practice of contingency fees — for example, when the lender receives money from the attorney and other agents to be the one used by the lender. Because of this, U. Lenders argue that including late fees and other conditional charges would require them to make assumptions about the consumer's behavior — assumptions which would bias the resulting calculation and create more confusion than clarity. Even beyond the non-included cost components listed above, regulators have been unable to completely define which one-time fees must be included and which excluded from the calculation.
This leaves the lender with some discretion to determine which fees will be included or not in the calculation. Consumers can, of course, use the nominal interest rate and any costs on the loan or savings account and compute the APR themselves, for instance using one of the calculators on the internet. In the example of a mortgage loan , the following kinds of fees are:. The discretion that is illustrated in the "sometimes included" column even in the highly regulated U.
With respect to items that may be sold with vendor financing, for example, automobile leasing, the notional cost of the good may effectively be hidden and the APR subsequently rendered meaningless. An example is a case where an automobile is leased to a customer based on a "manufacturer's suggested retail price" with a low APR: Had the customer self-financed, a discounted sales price may have been accepted by the vendor; in other words, the customer has received cheap financing in exchange for paying a higher purchase price, and the quoted APR understates the true cost of the financing.
In this case, the only meaningful way to establish the "true" APR would involve arranging financing through other sources, determining the lowest-acceptable cash price and comparing the financing terms which may not be feasible in all circumstances. For leases where the lessee has a purchase option at the end of the lease term, the cost of the APR is further complicated by this option.
In effect, the lease includes a put option back to the manufacturer or, alternatively, a call option for the consumer , and the value or cost of this option to the consumer is not transparent.
APR is dependent on the time period for which the loan is calculated. That is, the APR for one loan with a year loan duration cannot be compared to the APR for another loan with a year loan duration.
APR can be used to show the relative impact of different payment schedules such as balloon payments or bi-weekly payments instead of straight monthly payments , but most standard APR calculators have difficulty with those calculations. Furthermore, most APR calculators assume that an individual will keep a particular loan until it is completely paid off resulting in the up-front fixed closing costs being amortized over the full term of the loan.
If the consumer pays the loan off early, the effective interest rate achieved will be significantly higher than the APR initially calculated. This is especially problematic for mortgage loans where typical loan durations are 15 or 30 years but where many borrowers move or refinance before the loan period runs out. In theory, this factor should not affect any individual consumer's ability to compare the APR of the same product same duration loan across vendors. APR may not, however, be particularly helpful when attempting to compare different products.
Since the principal loan balance is not paid down during the interest-only term, assuming there are no set up costs, the APR will be the same as the interest rate.
Three lenders with identical information may still calculate different APRs. The calculations can be quite complex and are poorly understood even by most financial professionals. Most users depend on software packages to calculate APR and are therefore dependent on the assumptions in that particular software package.
While differences between software packages will not result in large variations, there are several acceptable methods of calculating APR, each of which returns a slightly different result. From Wikipedia, the free encyclopedia.