Interest rates ( interest rate ) and APR ( annual percentage rate ) are two frequently confused terms that refer to similar concepts but have subtle differences when it comes to calculation. When evaluating the cost of a loan or line of credit, it’s important to understand the difference between the advertised interest rate and the annual percentage rate (APR), which includes any additional costs or fees.
Interest rate.
The advertised rate, or nominal interest rate, is used to calculate the interest expense on your loan. For example, if you were considering a $200,000 home loan with an interest rate of 6%, your annual interest expense would be $12,000, or a monthly payment of $1,000.
Interest rates can be influenced by the federal funds rate set by the Federal Reserve, also known as the Fed. In this context, the fed funds rate is the rate at which banks lend reserve balances to other banks overnight. For example, during an economic downturn, the Federal Reserve will typically lower the fed funds rate to encourage consumers to spend money.
During periods of strong economic growth, the opposite will happen: The Federal Reserve will typically raise interest rates over time to encourage saving and balance cash flow.
In recent years, the Federal Reserve changed interest rates relatively little; between one and four times a year. However, in the 2008 recession, rates were gradually lowered seven times to adjust to market conditions. While it is not a determinant of mortgage or other interest rates, it does have a strong influence reflecting broader market conditions.
RWA definition.
The annual interest rate, however, is the most effective rate to consider when comparing loans. The APR includes not only the interest expense of the loan but also all the fees and other expenses involved in obtaining the loan. These commissions may include broker fees, closing costs, rebates, and discount points. They are often expressed as a percentage. The APR should always be greater than or equal to the nominal interest rate, except in the case of a specialized deal where a lender offers a refund of a portion of your interest expense.
When comparing two loans, the lender offering the lower nominal rate is likely to offer the better value, since most of the loan amount is financed at a lower rate.
The most confusing scenario for borrowers is when two lenders offer the same nominal rate and monthly payments but different APRs. In such a case, the lender with the lower APR is requiring fewer down payments and offering a better deal.
Using the APR comes with some caveats. Since the lender’s servicing costs included in the APR are spread out over the life of the loan, sometimes up to 30 years, refinancing or selling your home can make your mortgage more expensive than expected. originally suggested by the APR. Another limitation is the ineffectiveness of the APR in capturing the true costs of an adjustable-rate mortgage since it is impossible to predict the future direction of interest rates.
The final result.
While the interest rate determines the cost of borrowing, the APR is a more accurate picture of the total cost of borrowing because it takes into account other costs associated with obtaining a loan, particularly a mortgage. When determining which loan provider to borrow money from, it is essential to pay attention to the APR, that is, the real cost of financing
