Understanding the Difference Between Rates and APR

Category ยท First-Time Home Buyers

Published on October 5, 2018

When you're ready to apply for a loan for a big purchase, such as a home or auto, you want to make sure you understand everything about the process. That includes understanding the difference between interest rates and APR (or annual percentage rates).

Both interest rates and APR involve percentages. An interest rate is the small percentage added to the amount you will repay the lender of your loan. This rate is used to calculate your monthly payment. An APR also includes all of the cost of financing the loan, such as fees you pay to obtain the loan. While it's higher than the interest rate, it's not a factor in determining your monthly loan payment.

Interest Rates

A loan payment consists of the principal, or amount you borrow, and the interest, or percentage-based fee you pay for borrowing the funds. When you pay down the principal, it reduces the amount you owe the lender. But paying the interest doesn't do this.

Interest rates are either fixed or adjustable. A fixed rate remains the same for the life of the loan. However, an adjustable rate mortgage, or ARM, can fluctuate throughout the duration of a loan, causing your monthly payments to also change. The good news is that there's a cap on how much and how often ARMS can change. Plus, their rates don't change until after a certain number of years.

When you're planning to get a loan, you should compare interest rates because they're a large part of your monthly payment. The lower the interest rate, the less interest you pay over the life of your loan.

APRs

You can use an APR to understand the fees that come with a fix-rate loan. It helps you wrap your mind around the fact that there's more to a loan than just paying back the amount you borrow.

APR is typically compounded monthly. This makes calculating the rate a little more challenging. But if you're charged 2% APR each month and owe $1,000, your interest charge is $20. That means your monthly payment is $1,020. But if you don't make a payment one month, additional fees are added to the APR, making it $20.40 the following month.

Although that seems like an insignificant amount, it's not. If left unpaid, that amount compounds every month a payment isn't made and can build up to quite a sum. Lowering your APR means your monthly payments and total costs will be lower. In many cases, it also means getting out of debt sooner. Here are two steps you can take to lower the APR on your debt.

One way to think of the annual percentage rate is by considering it the price tag for your ability to obtain a loan. Just take the amount you owe and multiply it by the APR. That number is the price tag of your loan.

Fortunately, you'll always know the APR associated with your loan. That's because federal government requires lenders to disclose it before any agreement is made. That's especially helpful because you can shop around for the best APR before committing to one loan.

When you're shopping for a loan to buy a home, car, boat, or other large item, make sure you consider all the factors involved in that loan. Consider the interest rate, the APR, and your ability to repay the loan. Be sure to shop around for the lowest rates in both of these so you can get the best deal. It's also very important that you make sure you fully understand every fee involved with your loan and that you're comfortable making the monthly payments required to repay your lender. The more knowledge you arm yourself with, the better off you'll be.

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