In all our financial activities, from our bank and credit card accounts to our loans and mortgages, we are faced with interest rates that are added to the actual amount that we have or that we owe to the financial institutions.
There are several types of interest rates that are applied to investments and loans. Â Two of them are the Annual Percentage Rate (APR) and the simple Interest Rate. Â Mortgages charge these two interest rates on their accounts.
Annual Percentage Rate
The annual percentage rate is the interest rate applied to a loan, deposit account or investment for the whole year. Â Note rates and headlines rates are usually added to the APR by some lenders.
APR has two types: Â Nominal APR, which computes simple interest for one year and Effective APR, which includes a fee plus a compounded interest rate.
APR can be computed in three ways. Â One is by compounding the interest rate for one year without considering the fees. Â Another is the inclusion of fees that are added to the balance due which will be the basis for the computation of the compounded interest rate. Â The third one is by amortizing the fees as a second loan.
APR is dependent on the period of time when the loan is calculated. Â It is used to show the impact of different payment schedules, when some would prefer bi-weekly payments rather than monthly payments. Â For loans that has a period of interest only payment, the APR is higher.
Example:
A $100 loan payable in one month with 5% interest and a $10 fee. Â If there is no fee, this loan will have an APR of 79% but if the fee is included, the APR becomes 435%.
Interest Rate
An interest rate is the rate that a person’s investment or deposit account earns or it can also be the rate that he has to pay the entity from which he borrowed money. Â It does not cover any additional fees or charges.
Banks offer a certain interest rate for the money that people deposit with them. Â They earn by offering the deposited amount as loan to other individuals or entities at a higher interest rate than they pay for the deposit accounts.
The money market, bond market and currency market also have their own interest rates that the money invested in them earns.
Interest rates can either be Real (calculated by taking inflation into account) or Nominal (amount of interest payable).
Example:
If a person deposits $100 in a bank for a period of one year, with an interest rate of 10% per annum., the total amount in his account at the end of the year should be $110.
Summary:
1. Annual Percentage Rate is more complex, while Interest Rate is simpler.
2. Annual Percentage Rate includes fees, while Interest Rate does not include fees.
3. Annual Percentage Rate assumes that the individual will keep a particular loan until it is paid off, while Interest Rate does not.
4. Annual Percentage Rate is usually higher than Interest Rate.