FRANKLIN NEWSFLASH: Difference between interest rate and APR

Home buyers sometimes have a hard time understanding the difference between the interest rate on a mortgage and the Annual Percentage Rate (APR). But there is no need for confusion at all if you recognize that the costs associated with taking a mortgage loan goes beyond just the interest rate.

The interest rate is the percentage rate of interest you would pay over the mortgage tenure. This is the advertized or nominal rate and can be either fixed or variable (as you find in ARM).

So, if for example, you take a mortgage of $200,000 for 15 years at 5%, it means you would pay an interest of 5% ($10,000) on your mortgage every year, for 15 years (or about $834 monthly).

The APR on the other hand takes into account all the cost associated with getting the mortgage - the interest rate of 4.5% (from our example), your closing cost (whether or not you pay out-of-pocket), broker fees, discount points, mortgage insurance (if you took one) and other additional costs. The APR is calculated by adding up all the cost above and dividing by the loan tenure (15 years in this case).

The APR is also expressed as a percentage and gives you a more accurate measure of the cost of the loan to you. Every expense made in securing the loan is taken into consideration irrespective of whether they are one-off payments or spread out over a period.

How To Calculate APR

Using the example above, let us assume that in getting the mortgage, you paid a total of $4,000 (including all fees, points etc), it means your total loan value comes to $204,000 ($200,000+$4,000).

The 4.5% interest rate is then applied to the new loan value of $204,000 (4.5* 204,000/100) which gives us $9,180.

The APR is determined by dividing this new annual payment figure by the original loan amount of $200,000 and multiplying by 100 ($9180/$200,000*100). This equals 4.59%.

Some Implications Of APR

Taking the APR into account can help you save a lot of money when making decisions about your mortgage such as negotiating deals and refinancing. The Federal Truth in Lending Act requires lenders to disclose APR.

If your mortgage tenure is as long as 30 years and you plan to live there for that long, then it is better to go for a loan with a low APR so that you can optimize the value of the fees paid for the mortgage.

If your mortgage has a shorter life-span, you are better off with a higher interest rate and APR and pay fewer upfront fees. However it gets tricky at this point because you also need to consider your break-even point in order to ascertain the most cost-effective rate and APR for you.