Whether you are looking for a home mortgage, personal loan, or business loan, you probably see the interest rate or APR being advertised. While the two terms are similar, they refer to two different costs associated with a loan. Knowing the difference can help you choose the best loan and potentially save you thousands of dollars. Here, we explain what an interest rate is, what APR is, and why the difference matters.
What Is An Interest Rate?
An interest rate is the percent of the principal that the borrower pays when taking out a loan. Generally, personal loans and business loans have fixed rates while mortgages can have fixed or variable interest rates. A fixed-rate stays the same over the term of the loan, while a variable rate can increase or decrease with the current market price.
Interest rates are always illustrated as a percent. As an example, the Economic Injury Disaster Loan (EIDL) has a fixed interest rate of 3.75% for small businesses and a fixed interest rate of 2.75% for non-profits. Every year, businesses that take out an EIDL loan will pay 3.75% of the principal balance in interest. Current 30-year home mortgages interest rates are at 3.125%.
Your interest rate determines the percent of your principal you will pay each year in interest. For example, if you buy a home for $200K with a mortgage interest rate of 3%, you will pay $6K annually (or $500 per month) for the loan at the very beginning. As the principal amount decreases ($200K in this example), the amount you pay in interest decreases, even though the rate stays the same.
What Is An APR?
APR is an acronym that stands for "annual percentage rate." It is a broader measurement of the cost of your loan. The APR of a loan includes the interest rate for the loan, plus any fees related to the loan. Related fees can include but are not limited to the following.
- Mortgage broker fees
- Administrative costs
- Closing costs
- Discounts points or prepaid interest
- Private mortgage insurance
The APR is considered to be the true cost of a loan because it includes everything, not just the interest rate. Because the APR includes other fees, it is normally higher than the interest rate. The Truth in Lending Act of 1968 (TILA) requires lenders to make the APR known to borrowers, so if a lender only advertises the interest rate, ask for the APR. Additionally, loans covered under TILA allow the borrower three days to back out without losing any deposit or down payment.
Why Does The Difference Matter?
It is important to know the difference because the interest rate and APR because some lenders only advertise the interest rate. If you compare Lender A's APR to Lender B's interest rate, you will likely choose Lender B because it will look lower. However, Lender B's fees may be higher than Lender A's, meaning that you will end up paying more over the life of the loan.
For example, let's say Lender A's APR is 3% for a 30-year home loan. Lender B advertises an interest rate of 2.85%, but the APR is actually 3.25%. Over 30 years for a $200K house, you will pay $10K more for a loan through Lender B. It's critical to compare APR to APR so you know exactly what you are comparing and be confident in your choice.
Consider Your Options Carefully
Before purchasing a home or signing the line on a business loan or personal loan, it is important to compare the APR of different lenders to ensure you are getting the best deal you can. Not doing so can potentially cost you thousands of dollars. If lenders advertise the interest rate, ask for the APR.
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