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APR vs interest rate: What You Don't Know Can Hurt You

October 20, 2014

What's the difference between a loan's interest rate and its annual percentage rate, or APR? Not understanding APR vs interest rate could cost a borrower a lot of money. Along with advertised mortgage interest rates, lenders are required by law to display an APR. The interest rate is a useful figure -- it's what the lender uses to calculate a mortgage payment for a given loan amount and repayment period. However, the interest rate alone gives no information about the actual costs of the loan.

How Is APR calculated?

If it has an interest rate of 5.0 percent, a $100,000 loan with a 30-year term would carry a payment of $537 a month. Now suppose there are two loans in the picture. Both have 5.0 percent rates, but one costs $1,000 and the other costs $4,000. They're obviously not the same, even if they have the same payment! This is where APR vs interest rate comes into play.

In the example above, the payment for both loans is $537 per month. But because the first loan costs $1,000, the $537 monthly payment gets the borrower only $99,000, not $100,000. Using a financial calculator, a mortgage shopper could calculate the interest rate fort a $537 payment and a $99,000 loan amount. It happens to be 5.09 percent. The second loan costs $4,000, which means that same $537 payment only applies to a loan amount of $96,000. So in this case, the APR is 5.35 percent.

In these examples, it's pretty easy to see which loan is the better deal. An APR calculation isn't really necessary to prove that the first loan is the cheaper one. But what if a 5.0 percent loan costs $1,000 while a 4.5 percent loan costs $4,000? Which is the better deal? That's where calculating the APR comes in handy. The APR of the 5.0 percent loan is, as already stated, 5.09 percent. The APR for the second loan, however, is 4.85 percent. That means over the life of the loan, the second loan costs less than the first loan -- at least it does if the borrower keeps the mortgage for its entire 30-year term.

Is the Loan with the Lowest APR Always Better?

Many people assume that the loan with the lowest APR automatically gives them the most bang for their buck. Yet sometimes calculating the APR vs. interest rate is the only way to truly reveal what the best deal is. Low APR is great, provided the mortgage is paid off over the course of its entire term. If not, the upfront costs of getting a mortgage are spread out over a shorter period of time, which changes the true cost of the loan. This is where the upfront costs and the borrower's time frame become important factors.

Consider the example of the two $100,000 30-year fixed loans again. but this time assume that the buyer is going to sell the home in five years. Changing the first loan's term from 30 years to five years, its APR increases from 5.09 percent to 5.41 percent. And the second loan with its $4,000 in costs? That APR increases from 4.85 percent to a whopping 6.12 percent! For those with shorter time horizons, or those who don't know how long they will keep their loan, a mortgage with fewer upfront costs is often the best choice.

Adjustable Rate Mortgages and the APR

Because no one can predict how interest rates will change over the years, the APR for adjustable-rate mortgages (ARMs) is calculated on the assumption that the loan is adjusting at the time the disclosures are created. The APR disclosure for a 5/1 LIBOR ARM, then, would consider the current value of the LIBOR index, and perform calculations based on that value, even though it's highly doubtful that in five years, when the interest rate adjusts, the LIBOR will be at the exact same level it is today.

The most important thing to remember when comparing APRs of ARMs is that they are calculated based on current economic conditions. The APR of a loan on Monday may be different from the APR of that same loan on Friday, so getting mortgage quotes on the same day--and preferably at the same time--is advised. This is easiest to manage with the help of online marketplaces like LendingTree.com, which offers real-time rates and custom quotes and takes just a few minutes.

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