I get asked this all the time: What's the difference between interest rate and APR (Annual Percentage Rate)? Explanations that I have heard over the years have ranged and varied from the most complex analysis to just plain wrong. When buying a home, you should know since it affects your total mortgage obligation and give you an idea as to whether you're getting the most "bang for your buck".The people at Bankrate.com are some of the best at explaining in layman's terms the differences between these two. Here's what Michael Estrin had to say on the subject:
Understanding the difference between annual percentage rate, or APR, and interest rate could save you thousands of dollars on your mortgage. But if you're like most homebuyers, you probably don't know that the interest rate and the APR measure 2 important, but different, costs associated with your home loan.
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Interest rate and APR
The interest rate is the cost of borrowing the principal loan amount. It can be variable or fixed, but it's always expressed as a percentage.The APR is a broader measure of the cost of your mortgage because it reflects the interest rate, as well as other costs such as broker fees, discount points and some closing costs. The APR is also expressed as a percentage.
Why have both?
"The main difference is that the interest rate calculates what your actual monthly payment will be," says Sean O. McGeehan, a mortgage sales manager in Chicago. "The APR calculates the total cost of the loan. A consumer can use one or both to make apples-to-apples comparisons when shopping for loans."For example, a loan with a 4% rate will have a lower monthly payment than a loan with a 6% rate, assuming both are fixed for the same term. Likewise, the total cost of a loan with a 4% APR will be less than one with a 6% APR.
Where it gets tricky
Separately, the interest rate and the APR have their limits. But together, borrowers should be able to use both figures to determine their monthly payments, as well as their total costs. The trick, says McGeehan, is to understand the interplay between the 2 figures."If a consumer is only focused on getting the lowest monthly payment, they should focus on the interest rate," says McGeehan. "But if the consumer is focused on the total cost of the loan, then they can use the APR as a tool to compare the total cost of 2 loans."
This chart shows the interest rate, APR and total costs over time for a $200,000 mortgage in which 1.5 discount points cut the interest rate by one-quarter of a percentage point, and another 1.5 discount points cut the interest rate by a further quarter of a percentage point.
| Interest rate | 4.5% | 4.25% | 4% |
|---|---|---|---|
| Discount points | 0 | 1.5 | 3 |
| Points and fees | $2,800 | $5,800 | $8,800 |
| APR | 4.619% | 4.492% | 4.36% |
| Monthly payment | $1,013 | $984 | $955 |
| All costs, 3 years | $39,281 | $41,220 | $43,174 |
| All costs, 10 years | $124,404 | $123,866 | $123,380 |
| All costs, 30 years | $367,613 | $354,197 | $343,739 |
Remember that the greater differentiation between your interest rate and your APR, the more fees you are paying.
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