Understanding the difference can save you money
APR vs. interest rate: what’s the difference? Is it important to know? How do lenders calculate the two? Which should I use ? These are all good questions!
I have good news! The purpose of this article is to educate you about interest rates and the APR, their differences and how they are calculated.
Interest rate is a general term for loans and lines of credit, and understanding how it works is a relatively straightforward task. But what about the RPA?
APR is another common term in finance, but many people don’t understand its meaning, how it differs from the interest rate, and how it affects borrowing money.
Understanding the APR for a loan or line of credit is essential because it gives you a general idea of the cost of such a loan over the long term.
With this brief introduction, let’s go.
APR vs interest rate
The nominal interest rate, or advertised rate, refers to the percentage that you have to pay during a specific period to borrow money from a lender. The interest rate is represented as a percentage, and it can be fixed or variable. Although the interest rate can be fixed for any period, it is usually expressed as an annual rate.
For example, you borrow $ 3,000 with an interest rate of 5% for 12 months. At the end of the 12 months, you will end up paying $ 150 in interest, bringing your total to $ 3,150 ($ 3,000 in principal + $ 150 in interest).
There are many factors that can affect the interest rate you receive from a lender, including, but not limited to, the overall economy, financial markets, debt-to-income ratio, credit score, and amount. paid for the down payment. Your debt ratio and your credit score play a vital role in determining what is known as your creditworthiness.
Interest rates can vary widely depending on the type of credit or loan you are trying to get and the factors mentioned above. They can range from 0% (typically advertised for certain vehicles, appliances, and other items as a means of attracting customers), up to over 30% for personal loans to those with low creditworthiness.
Knowing the interest rate on a loan is crucial. Not only to decide whether to take out a new loan, but also to develop a plan to repay existing debt, using strategies such as Debt Snowball and Debt Avalanche.
Variable vs fixed interest rate
Interest rates can be fixed or variable.
A fixed interest rate will never change, no matter if the external factors that typically influence interest rates change, such as the financial markets. So, with a fixed interest rate, your interest rate stays the same throughout the life of the loan.
A variable interest rate, on the other hand, can vary over the life of your loan. This is because variable interest rates are tied to an index rate, and if that index rate changes, your interest rate also changes.
The annual percentage rate, or APR, includes the interest rate on the loan and all other costs related to it, such as fees, closing costs, points of call, etc.
Same as the interest rate, the APR is also expressed as a percentage and, in the majority of cases, it must be equal to or greater than the interest rate.
Let’s use the same example we used above for interest rates:
You borrow $ 3,000 at an interest rate of 5% for 12 months. To process the loan, the lender charges you a processing fee of $ 30. At the end of the 12 months, you will end up paying a total of $ 3,180 ($ 3,000 in principal + $ 150 in interest + $ 30 in fees). In this case, the APR is 6%.
The APR gives you an overview of how much it costs you to borrow money. However, it is essential to consider both the interest rate and the APR when comparing loans.
The fees associated with your loan depend on the type of loan you are applying for. Here are some of the most common:
- Application Fee: Some lenders charge a fee just for applying for a loan, and you are responsible for it whether you qualify or decline.
- Origination costs: costs intended to remunerate the lender for the work necessary to constitute the loan.
- Processing Fee: A general term for all additional fees, many of which are negotiable.
- Application fees: fees intended to cover the efforts required to draft the loan documents.
- Underwriting commission: fees charged to cover the underwriting costs, the person who reviews the loan application and makes the final decision whether or not to grant credit.
- Dealer preparation: additional costs generally added by dealerships when taking out a car loan.
To go further, credit cards can have multiple APRs, and it is essential to know them and understand their difference:
- Introductory APR: rate given for a temporary period, usually to attract consumers. After the initial introductory APR is completed, the Regular Purchase APR kicks in.
- Purchase APR: the regular rate billed to you for the balance carried over month after month.
- APR penalty: the rate at which your credit card company can legally hit you if you go over your credit limit or fail to make your payments.
A little history of the RPA
At the turn of the 20th century, bankers and creditors could charge whatever interest rate they wanted, as there were no regulations in place. This often meant averages of 10% for mortgages and up to 500% annual interest rates for private loans. In many cases, lenders are using lower interest rates as a bait, but high fees have been hidden and not disclosed to consumers upfront.
The Truth in Lending Act (TILA) was enacted as federal law in 1968 to protect consumers when dealing with lenders.
One of the most significant changes TILA made was in the information lenders had to disclose to consumers, such as the Annual Percentage Rate (APR), loan terms, and total borrower costs. This information should be presented to the borrower before signing any document and, in some cases, on periodic billing statements.
How lenders calculate the interest rate
Lenders calculate your interest rate using your data. Each lender has their formula for calculating the interest rate, so you will likely get five different rates from five lenders.
While you don’t have much control over the actual interest rate you get, there are things you can do to increase your creditworthiness and thereby improve the interest rate that lenders are offering you. . These include your credit score and your debt-to-income ratio.
- Credit Score: A number from 300 to 850 that tells lenders, at a glance, how well you are managing credit. There are many factors that go into calculating your credit scores, such as payment history, credit usage, length of credit history, new credit, and credit composition.
- Debt-to-Income Ratio (DTI): This is the percentage of your gross monthly income related to debt. This shows lenders your ability to handle the monthly payments for any new debt you plan to acquire. A DTI of 35% or less is considered good, with some cases such as a home loan, bringing that number to around 43%.
- Government Guaranteed Loan: Another way to lower your interest rate is to use government guaranteed loans such as VA, FHA, or USDA loans. These are insured by the federal government and generally carry a lower interest rate than conventional loans.
How lenders calculate the APR
Things are a little different when it comes to the APR, and unfortunately you have less control over it because your lender controls all of the fees that, along with your interest rate, make up your APR.
However, one of the things you can do to lower your APR, at least when it comes to taking out a home loan, is to put down a down payment of at least 20%. This will allow you to avoid private mortgage insurance (PMI) and, in turn, lower your APR.
Plus, you can lower your APR by simply negotiating the lender’s fees or buying discount points on home loans.
- Discount points: Discount points allow you to purchase “points” in exchange for a lower interest rate. You trade in a higher upfront cost (pay points) for a lower monthly payment, which saves you money over time.
APR vs. Interest Rate – Which One Should You Use?
So now you understand what interest rate and APR are. But, which one should you trust when comparing loans? Unfortunately, the answer is, it depends.
While the APR gives you an overall idea of the cost of a particular loan, a lower APR doesn’t necessarily mean the loan is better for you.
For this reason, it is always important to consider both the interest rate and the APR of the loan. As part of this equation, knowing or estimating whether or not you’ll pay off the loan sooner makes a difference.
In some cases, such as with a mortgage, a loan with a higher APR and lower fees can be cheaper if you keep the loan for a shorter term, which means you pay off the loan sooner or end up. refinance or sell the loaned asset. .
- If you plan to hold on to the loan for the life of the loan, all you need to do is compare the APRs of different lenders to tell you which loan will cost you less over time.
- If you plan to pay off the loan sooner, you can’t just rely on the interest rate or APR numbers when comparing loans. A loan with a higher interest rate and APR, but lower fees, can cost you less if you keep it for a shorter period.
This scenario occurs because, initially on a mortgage, you are primarily paying a fee, and therefore the interest rate does not play a significant role until years later in the loan.
What if you had the money to pay for something up front? Should I take out a loan or pay it off in full? Understanding what is called opportunity cost can answer this question.
Knowing the interest rate and APR of a loan is essential for comparing several loans or simply for deciding whether taking a loan is the right choice.
However, it is not as simple as choosing the lower interest rate or the APR, as we have learned. It is also essential to understand the term of the loan and whether you plan to keep it that long or not.
Having a complete picture of a loan you are considering taking can help you make the right financial decisions about whether or not to take out a loan, pay off an existing loan sooner, or invest the money instead.
And don’t forget that there are things you can do to improve your creditworthiness, and therefore the interest rate you receive from lenders. Plus, you can still negotiate the lender’s fees and, in turn, lower your APR.