Financial Education
Defining terms: Interest rate and APR
Interest Rate and APR are definitely the most commonly confused terms in lending. Understanding these terms and how they affect your loan will make you a much smarter borrower.
The first misconception is that the APR (Annual Percentage Rate) is the rate of interest you pay on a loan. APR is NOT the interest rate used to calculate your loan payments. If this were the case, lenders would not quote the interest rate and APR separately, right? APR includes the cost of fees incorporated into a final loan cost, broken down into an annual percentage over the course of the loan.
The interest rate (not APR) is the true rate of interest paid on your loan. This means that if you get a loan with an interest rate of 7.500%, your monthly payments are calculated at 7.500% regardless of what your APR is. Pretty simple.
Now let's look at an example:
John borrows $5,000 at an interest rate of 7.5 percent for two years. John's monthly payment for this loan is $225. Could we derive the APR amount from this information? No. Because we don't know what the cost of the loan is, or in other terms, what mandatory fees are associated with the loan.
Now let's look at what the APR is, based on different closing costs. The more costs or fees you have for the loan, the higher your APR will be. The monthly payment and interest rate will not change. There is no need to worry if your APR and interest rate don't match, because they rarely will. Note the following table:
| Loan Fees | APR | Interest Rate | Monthly Payment |
|---|---|---|---|
| $0 | 7.500% | 7.500% | $225 |
| $10 | 7.700% | 7.500% | $225 |
| $20 | 7.900% | 7.500% | $225 |
| $30 | 8.100% | 7.500% | $225 |
As you can see, as the cost of John's loan increases, so does the APR. But the monthly payment always remains the same because the interest rate is the same. This is a clear indication that APR does NOT determine your monthly payment, but merely expresses the existence of loan costs.
Why would the APR be higher on some loans than on others? There could be a multitude of reasons. When you ask for an immediate loan, you will have to pay for the speed at which the loan is processed. Therefore, your APR may be higher because your fees are higher. Also, you may have more fees associated with your loan because you are a "high" risk to the lender. If you have had credit problems in the past and have not paid your bills on time, not only will your interest rate be higher, but so will your APR.
Let's say you need a loan and you see advertisements from three different lenders in the Sunday newspaper. The following table is a comparison of the rates and APR that each lender is advertising:
| Lender A | Lender B | Lender C | |
|---|---|---|---|
| Loan Amount | $5,000 | $5,000 | $5,000 |
| Loan Term | 2 year | 2 year | 2 year |
| Interest Rate | 7.500% | 7.500% | 6.990% |
| Loan Fee | $10 | $20 | $30 |
| Monthly Payment | $225 | $225 | $224 |
| APR | 7.698% | 7.897% | 7.585% |
By looking at the numbers, you immediately know that Lender C will have the lowest monthly payment. Why? Because they are offering the lowest interest rate.
Remember: don't pay attention to the APR when assessing the monthly payment. The bottom line is that the lowest Interest Rate will always equal the lowest monthly payment, regardless of the APR. To demonstrate, take a look at the table below to see what the monthly payment will be for each lender based on a loan amount of $150,000:
| Lender A | Lender B | Lender C | |
|---|---|---|---|
| Loan Amount | $150,000 | $150,000 | $150,000 |
| Loan Term | 30 Year Fixed | 30 Year Fixed | 30 Year Fixed |
| Loan Type | Conforming | Conforming | Conforming |
| Interest Rate | 7.500% | 7.500% | 6.000% |
| Loan Fee | $2,000 | $3,000 | $4,000 |
| Monthly Payment | $1,049 | $1,049 | $899 |
| APR | 7.638% | 7.708% | 6.254% |
Now, the remaining question is: "What is the difference between Lender A and Lender B?" By reviewing the tables above you will see that the only difference between them is the APR. The interest rate is the same and thus, the monthly payment is the same. So again, what exactly does the difference between the two APRs tell you?
Well, if you remember that APR is really a way of indicating loan fees, then it should be pretty clear that Lender B is charging more in loan fees than Lender A. It's that simple.
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