The financial needs of businesses and individuals are increasing day by day and many a times, they have to borrow the money (i.e. Mortgage or loan) from financial institutions in order to meet their financial goals. In exchange of the borrowed amount, they are required to pay a certain percentage of that amount to financial institutions on a regular basis. This cost is commonly known as an Annual Percentage rate (APR) or Interest Rate. Although, people use these terms interchangeably but there is a difference between these two amounts.
Whenever you evaluate the terms of your loan or mortgage, it is important for you to understand the difference between APR and rate of interest. Some of the differences are discussed below.
Definition
The rate of interest is the cost of taking a loan and is generally defined in percentage. It does not include any fees or other charges that are required to be paid when you borrow money. It compensates the banks and financial institutions for giving up other investment opportunities that could have been taken up with the borrowed amount.
Annual Percentage Rate or APR, on the other hand, is a broader measure of borrowing cost as it includes interest, fees and other charges that are required to be paid to financial institutions when you borrow money. This is the reason why it is usually higher than the rate of interest.
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The rate of interest charged by the lender may be lower as compared to the APR, but the upfront cost will be higher. For example, you are supposed to pay a large sum of closing cost when you buy a property. Therefore, when all the associated cost of the loan is taken into consideration, a lower rate of interest may turn out to be very expensive option for the borrower. Moreover, it is not a reasonable measure to compare different lenders as it does not include any charges or fee.
Whereas, Annual Percentage Rate represents the effective rate of interest, which takes into account all the associated cost of borrowing. As a result, it allows a reasonable and better measure to compare the lenders. However, it is important to note that the APR is not very accurate when it comes to Adjustable Rate Loans, because it is not possible to predict the market rates that will be prevalent in the future. For example, the average rate of interest for a thirty year fixed rate loan was around 13 percent in the early 80s, which is two times more than the current rate.
Transaction Cost and Other Fees
As already discussed, the calculation of APR factors in all the costs and fees, which means it also includes the transaction cost, but when you are calculating the rate of interest, no transaction cost is included in its calculation.
Many financial institutions have a requirement of Private Mortgage Insurance (PMI) if the down payment is less than 20% of the value of property. Unlike the calculation of the interest cost, APR calculation also accounts for the cost of PMI.
Discount Points
Discount points are another factor why APR is higher than the rate of interest. When a borrower makes an upfront payment of discount points, he actually pays it to reduce the overall rate of interest over the life of a mortgage or a loan. Each point is equal to 1 percent of the loan, which means it will reduce the rate of interest by 0.125 percent, for example, if a person is paying 10 percent interest on a loan amount, he can reduce it to 9.875 if he pays for one discount point.