What is the difference between interest rate and APR (Annual Percentag

What is the difference between interest rate and APR (Annual Percentage Rate)?

There are many costs associated with taking out a mortgage. These include the interest rate, points, fees, and other charges.

The interest rate is the cost of borrowing money expressed as a percentage rate. It does not reflect fees or any other charges you may have to pay for the loan.

Let’s begin with some definitions:

What is the interest rate?

The interest rate is the percentage of the loan amount that is charged for borrowing money.We can consider this the base fee.It is very important when comparing loan quotes since it directly affects monthly payments.

What is the APR (Annual Percentage Rate)?

The APR is a calculated rate that not only includes the interest rate but also takes into account other lender fees required to finance the loan.The idea behind APR is to help consumers understand the tradeoffs between interest rate and the fees paid at closing (such as paying higher fees to lower interest rates or increasing interest rates to cover closing costs).

How APR is calculated;

To calculate the APR, the lender fees (fees required to finance the loan) are incorporated into the interest rate.This is done by amortizing the fees out over the life of the loan as if they were additional payments, and then calculating a new rate.

Specifically:

The fees are added to the original loan amount ($200,000 + $3,000) to create a new loan amount ($203,000).This new loan amount, along with the interest rate (5.00%), is used to calculate a new monthly payment ($1089.75).The APR is then calculated by working backwards to figure out what the rate would have to be for a loan with the new monthly payment ($1089.75) and the original loan amount ($200,000).This is your APR (5.13%).The APR is typically higher than the interest rate because it includes the fees.

Limitations of APR

As useful as the APR can be, it has its limitations.APR spreads the fees paid upfront over the life of the loan.So the comparison of APR is only accurate if you plan to keep the mortgage for the entire length of the loan.

Comparing Apples or Oranges, But Not Both

The important thing to remember is that APR is not the metric for comparing mortgages -- it's merely a metric. The better way to compare two mortgage rate offers is to look at the mortgage rates as compared to the fees. APR should have nothing to do with it.

Experts recommend that you shop for a specific mortgage rate, then compare loan fees across banks at that specific rate. Or, shop for zero closing costs whatsoever and compare mortgage rates across banks. You can't do both at once and can't shop for a mortgage by APR.