They may sound similar and are often used in the same breath when talking about loans, but an interest rate and the annual percentage rate (APR) are very different even though both involve the cost of borrowing money and how much you’ll end up paying your lender. When evaluating the cost of a loan or line of credit, it is important to understand the difference between the advertised interest rate and the annual percentage rate (APR). Before comparing them, let’s do a little review.
What Does Interest Rate Mean?
Your annual interest rate refers to the cost of borrowing money on the principal loan amount – in other words, the amount of interest you’ll pay. It is ultimately determined by your creditworthiness. Along with your principal loan balance, your interest rate is used to calculate your estimated monthly payment.
What Does APR Mean?
The APR is a more encompassing measure of the actual cost of borrowing and is also expressed as a percentage. It includes the mortgage interest plus other transaction costs and fees associated with obtaining a mortgage. These fees can include discount points, lender fees, closing costs, and more. However, closing costs vary by lender so it’s important to ask your lender what is included in the APR.
Comparing Interest Rate and APR
Both the APR and interest rate reflect the cost of a loan, but one is much more specific than the other. The interest rate is only based on the cost of borrowing money. On the other hand, the APR factors in the cost associated with obtaining a mortgage loan. It incorporates all of the borrowing costs for your home loan plus any additional fees that come with the loan to give you a better idea of the overall costs of your loan.
Understanding Their Importance
It’s important to understand the difference between an interest rate and an APR. Armed with knowledge of how each works, you can shop with added insights for the most affordable rates. For instance, if you’re comparative shopping for loans and you see multiple lenders offering the same interest rate, but a different APR, the lender with the lower APR is usually disclosing lower lender fees and or lower closing costs. However, it should be mentioned that not all closing costs (such as hazard insurance and property taxes) are included in the APR, so it’s important to ask your lender what costs are included so your loan comparisons are accurate.) The bottom line is that when you shop for a mortgage, you may start with interest rates, but an APR is a more accurate measure of the cost of obtaining a mortgage loan.
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