Tuesday, August 23, 2011

What is the difference between interest rate and APR (Annual Percentage Rate)?

This question comes up a lot, so this post will help explain the difference between interest rate and APR (Annual Percentage Rate). Basically, think of the interest rate as the starting point in what you will pay for a mortgage loan and then, tack on associated fees to calculate the APR.

Let’s begin 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 calculated rate that not only includes the interest rate but also takes into account other lender fees required to finance the loan. The idea behind APR is to help consumers understand the tradeoffs between interest rate and the fees paid at closing (such as paying higher fees to lower interest rates or increasing interest rates to cover closing costs). The government thought this was important so they required it to be shown next to the interest rate as part of the Truth in Lending Act.

Here is a diagram showing how APR tries to balance interest rate and fees:

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.

Specifically: (feel free to skip this paragraph)
The fees are added to the original loan amount ($200,000 + $3,000) to create a new loan amount ($203,000).  This new loan amount, along with the interest rate (5.00%), is used to calculate a new monthly payment ($1089.75).  The APR is then calculated by working backwards to figure out what the rate would have to be for a loan with the new monthly payment ($1089.75) and the original loan amount ($200,000).  This is your APR (5.13%).  The APR is typically higher than the interest rate because it includes the fees.

Limitations of APR
As 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.  See the post on whether or not you should pay points to learn more about the tradeoffs of paying interest upfront versus 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. @FirstCapitalMtg

Original Post -Author: Nate Moch

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