What is the difference between the interest rate and the A.P.R.?

The APR is an all-inclusive, annualized cost indicator of a loan. It includes interest as well as fees and other charges that borrowers will have to pay.

Borrowers often confuse APR with the interest rate. The interest rate is the amount of compensation per period for borrowing money and includes the cost of principal only.

While valid, interest rates do not offer the accuracy needed to determine which rate from which lender amounts to the best deal. Since the APR includes both interest and fees, it addresses this challenge by factoring into the interest rate and other additional costs associated with the loan.

In the U.S., the Truth in Lending Act requires lenders to display APRs so borrowers can easily compare lending costs between competitors. Of course, every lender is different, and the fees listed below will not apply to every loan. For this reason, prospective borrowers should ask lenders to list out all added costs packaged into individual APRs to understand a specific loan. For mortgage loans in U.S., APRs may include fees such as:

Fees usually exempt from the APR of a mortgage loan include:

• Appraisal fees
• Survey fees
• Title insurance and fees
• Builder Warranties
• Pre-paid items on escrow balances, such as taxes or insurance
• Intangible taxes

Limitations of the APR

While the APR serves as an excellent indicator for loan comparisons, the listed fee structure presumes that the loan will run its course. For any borrower planning to pay their loan off more quickly, the APR will tend to underestimate the impact of the upfront costs.

For example, upfront fees appear significantly cheaper spread out over a 30-year mortgage compared with a more accelerated 10-year repayment plan. In the U.S., borrowers usually pay off 30-year mortgages early due to reasons such as home sales, refinancing, and pre-payments. Therefore, when comparing loans with the same APR, the loan with lower upfront fees is more favorable to borrowers intending to pay off a mortgage early.

Types of APRs

Lenders should also understand the two different types of APR loans. Banks offer both fixed and variable APR loans, and each loan type comes with pros and cons.

Fixed APRs

Loans with fixed APRs offer steady rates for the duration of the loan. For this reason, borrowers receiving an attractive fixed rate should consider locking it in during a period of relatively low market interest rates due to the likelihood that rates will rise later. Fixed rates are generally higher than variable rates at the time of loan origination.

Variable APRs

Loans with variable APRs include rates that may change with time. These rates tend to rise and fall with an index such as the Federal Funds Rate. For instance, if the market interest rates rise, variable APRs tied to that index will probably also increase.

Borrowers should also be aware of another component to variable APRs called a credit-based margin. Lenders create credit-based margins, which use creditworthiness rather than the market index to determine a portion of the APR. Including the credit-based margin for each individual can prevent borrowers with poor credit scores from obtaining a lower variable rate assuming the lender will grant them the loan at all.

Nonetheless, borrowers should consider variable rates under some circumstances. Suppose a borrower takes out a loan during a time of relatively high market rates when analysts forecast rate declines. In that case, variable rates will probably lead to lower overall interest payments. Historical data has shown that borrowers generally paid less interest with a variable rate than a fixed-rate loan.

Additionally, borrowers should consider the duration of the loan. Generally, the longer the loan term, the greater the impact of rate fluctuations. This means that movements in interest rates can more deeply impact a 30-year loan than a loan with a 10 or 15-year term.