Some people believe that a loan’s interest rate and its annual percentage rate (APR) are the same thing. They’re not.
What is interest?
Interest is the money a borrower pays to a lender for the privilege of borrowing money. If lenders did not charge interest, they would make no profit by lending money. Interest is the money a lender makes for the service of lending money.
What is an interest rate?
When a lender makes a loan, he charges interest that is equal to some percentage of the loan amount. This percentage is the interest rate.
What is an APR?
APR stands for annual percentage rate. It equals the interest rate plus any fees and minus any rebates offered by the lender. Usually, these fees and rebates are settled up front. The APR takes those fees and rebates and spreads them out over the full life of the loan. The goal is to show borrowers the true lifetime cost of a loan, so that it can be more easily compared to other loans.
For instance, let’s use an APR calculator to compare two 30-year loans. They both have a 6% interest rate, but Loan A has $2000 in fees, and Loan B has $3000 in fees:
Loan B has a higher lifetime cost than Loan A. That’s a simple example, since the loans have the same interest rate, and one loan has an obviously higher fee. But what if Loan A has a 5.7% interest rate with $2000 in fees, and Loan B has a 5.8% interest rate with $1200 in fees? Which is more expensive, overall?
Now we can see that, again, Loan B has a higher lifetime cost, thanks to its higher APR.
Should I consider only the APR when comparing loans?
Not at all. It’s important to remember that the APR is calculated with the assumption that you’ll be keeping your home for the full life of the loan; commonly 30 years.
Most people do not keep the same loan for 30 years, meaning that the APR calculation may not be the most accurate measure of the true-life cost of your loan.
Instead, try asking your lender or broker to show you what the APR of your loan would be if your loan had a lifetime of 5, 7, 10, and 15 years. If you pay more fees or points up front to get a lower lifetime interest rate, you may not keep your home long enough to enjoy that low interest. It’s a bit like reserving a hotel room for a week to get a better rate, but using the room for only two nights.