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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.
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 rate 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.
In the past few years, the Fed changed interest rates relatively rarely, anywhere from one to four times a year. However, back in the Great Recession of 2008, rates were gradually decreased seven times to adjust to market conditions. While not the only determinant of mortgage or other interest rates, the fed funds rate does have a big influence, reflecting larger market conditions.
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.
Borrowers can use the APR as a good basis for weighing certain costs of loans, while also comparing actual underlying interest rates.
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.
The federal Truth in Lending Act requires that every consumer loan agreement provide the APR along with the nominal interest rate to disclose a loan's costs.
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 of $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%.
When comparing two loans, the lender offering the lowest nominal rate is likely to offer the best value, because the bulk of the loan amount is financed at a lower rate.
The scenario most confusing to borrowers is when two lenders offer the same nominal rate and monthly payments but different APRs. In a case like this, the lender with the lower APR is requiring fewer upfront fees and offering a better deal.
The use of the APR comes with a few caveats, however. Because the lender servicing costs included in the APR are spread out across the life of the loan, sometimes as long as 30 years, refinancing or selling your home may make your mortgage more expensive than originally suggested by the APR. Another limitation is the APR’s lack of effectiveness at capturing the true costs of an adjustable-rate mortgage (ARM), as it is impossible to predict the future direction of interest rates.
Both the interest rate and the APR on a loan reflect the cost to borrow money from a lender for a specified period of time. However, they differ in how they are calculated, what they represent, and how much control a borrower has over each.
In addition, there are strategies to consider when entering into agreements. Although a buyer may be tempted to jump at the lowest rate, this may not always be the most advantageous. For example, consider a homebuyer deciding whether to minimize their interest rate or minimize their APR.
By pursuing the lowest interest rate, the borrower may secure the lowest monthly payments. However, imagine a situation where a lender can choose between one loan charging 5% and one loan charging 4% with two discount points (about 2%). In this case, a higher interest rate may be favorable.
APR is composed of the interest rate stated on a loan plus fees, origination charges, discount points, and agency fees paid to the lender. These upfront costs are added to the principal balance of the loan. Therefore, APR is usually higher than the stated interest rate because the amount being borrowed is technically higher after the fees have been considered when calculating APR.
APR can't be less than the stated interest rate, although APR and the stated interest rate can be equal. APR usually includes additional fees that you’ll pay for the loan and is a more inclusive representation of all of the costs you’ll encounter when borrowing. If there are no additional costs or fees to secure the credit, then your APR and interest rate may be equal.
Yes, 0% APR means you pay no interest on the transaction. Be mindful that some 0% APR agreements may be temporary (i.e., 0% APR for six months, then a higher APR afterward). In addition, 0% APR transactions may still incur upfront or one-time fees.
APR is the overall cost to borrow money, so a lower APR is better for a borrower than a higher APR. APR will also vary based on the purpose of the loan, duration of the loan, and macroeconomic conditions that affect the lending side of the loan. In general, the best APR is 0%, in which no interest is paid, even if temporary for a short introductory period.
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.
