Understanding the Difference Between APR and Interest Rate

Written by: Mike Valles

When you start considering the interest rates on your new mortgage, you need to be sure that you understand the difference between APR and interest rate. Not knowing the difference could mean that you end up paying thousands of dollars more, paying more each month than you expected, and not getting the ideal home loan you thought you had.

The Interest Rate

The interest rate on a home mortgage, or other loan, is what you will pay during the course of an entire year. Generally, though, the difference between APR and interest rate, is that the interest rate does not include any added costs, such as the cost of fees or charges to process the loan. According to Cornell University, it is legal to do this, and several things can be excluded from interest rate reporting, such as the cost of credit reports, loan fees, broker fees, service charges, amounts payable under a discount, a point, or similar charges.

Interest rates are often used to hide the actual amount you will be paying during the course of the year. It also does not take into account compounding interest.

The Annual Percentage Rate (APR)

Whenever you get a loan, or credit, you will often see the annual percentage rate, or APR. This rate is the amount that you will actually pay per month on the balance. However, the truth is, and what many lenders do not want you to know, is that it only applies if there is no previous balance, says Investopedia.

When getting credit, apart from learning the difference between APR and interest rate, you also need to know the difference from APR and APY (annual percentage yield), says Investopedia. When you consider compounding interest, it is quite possible that a mortgage quoted to be 5.0 percent, could end up becoming 5.11% if compounded monthly, or 5.09 percent if compounded quarterly.

Use the APR When Comparing Mortgages

The APR is the figure that you should compare with other loan offers, says Dr. Don Taylor at BankRate.com. If you are getting a mortgage, it includes the cost of any fees that are going to be added to the mortgage. The extra fees are what will make two loans with the same interest rate good or bad. The APR will enable you to tell the difference.

If there is a significant difference between the interest rate and APR, costs such as discount points may be included. Buying discount points to get a lower interest rate is actually just paying some of the interest in advance. Although APR is excellent for understanding overall costs of a home mortgage, GetSmart.com says that it is not as accurate when it comes to adjustable rate mortgages, simply because future interest rates cannot be accurately predicted.

Once again, knowing the difference between APR and interest rate can also help you if you plan to stay in a home for just five to seven years. Because it may not make a lot of sense to pay a lot of fees up front, looking at the APR on a mortgage can save money on the short term, too. A mortgage normally spreads the fees over the lifetime of the mortgage, but paying a larger percentage up front with a higher APR will result in paying a greater percentage of them than you would otherwise have to do.


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