Nearly all loan types come with two interest rates: the actual interest rate and annual percentage rate, or APR. Though the disclosure of both rates is done primarily to help borrowers decide what the true cost of loans are from one lender to another, they often confuse borrowers in the process.
Interest rate is the basic rate charged on a loan. It is sometimes referred to as the “note rate”, mostly by lenders, and will be the interest rate of record in all loan documents.
Your loan payments will be based on the total amount of the loan, multiplied by the interest rate, plus loan principal repayment (based on the required loan amortization).
Annual Percentage Rate, or APR
APR is the effective rate on a loan, after subtracting required loan fees from the face amount of the loan. Unless the loan involves no required closing costs, the APR will always be higher than the actual interest rate.
APR is a rate that government regulators require lenders to disclose to prospective borrowers. Since lender fees can vary widely from one lender to another, APR makes it easier for borrowers to determine the true cost of one loan versus another when all lender fees are reflecting in the calculation.
Fees Included in the APR Calculation
There is some debate as to exactly which fees affect APR and which don’t. Some of the confusion has to do with different loan types. Mortgages, for example, generally include by far the largest number of loan related fees. There are also fees that relate to the purchase of real property that aren’t related to the loan used to buy it. Complicating this even further is the fact that certain fees relate to both the home purchase and the loan.
Below is a list of fees commonly included in APR calculations. The list is not all inclusive, and there may be fees listed here that some lenders don’t include in their APR calculations.
- Application fee
- Attorney fee (lender’s attorney)
- Loan origination fee
- Loan discount fee, or points
- Credit life or disability insurance (if required)
- Commitment fee
- Mortgage insurance premium (if required)
- Mortgage broker fee
- Loan assumption fee (more common with mortgages than other loans)
- Tax service fee
- Underwriter fees
- Processing fees
A sampling of fees typically not included in APR:
- Real estate commission
- Homeowner’s insurance
- Real estate taxes and insurance escrows
- Tax stamps
- Borrower’s title insurance
A sampling of fees that are subject to debate:
- Per diem interest charges
- Credit report fee
- Appraisal fee
- Recording fees
How APR is Calculated
If you apply for a loan of $100,000 at an interest rate (note rate) of 5%, with $5,000 in lender fees, you are only receiving $95,000 in loan proceeds. The interest rate is 5%, but when the payment is calculated based on the reduced loan proceeds received, the APR, or effective rate you will be paying will be higher than 5%. If the loan is payable over 10 years, the APR will be 6.125%.
The APR will be affected not only by the amount of lender fees paid, but also by the length of the loan and the type of charges. For example, some lender fees – like private mortgage insurance – are ongoing during the term of the loan. Others are flat fees paid on a one-time basis. Each fee type will affect the APR in a different way.
Annual Percentage Rate (APR)
|What it is||The annual charge – expressed as a percentage of the principal amount of a loan – required by a lender in order to make a loan||The effective annual percentage rate charged on a loan, after applying the interest rate to the net proceeds of a loan as a result of deducting the upfront fees required to obtain the loan|
|Why it’s used||Interest rate is the “note rate” – the rate contained in the loan documents representing the lenders return as compensation for providing the loan||Interest rates can be identical from one lender to another, but loan fees can vary widely; since APR reflects effective rates based on loan principal net of lender fees, it enables consumers to get a more accurate picture of actual rates on loans from different lenders and loan programs|
|When is it used||Primarily by lenders in establishing expected rate of return on loans, as well as for calculation of required loan payment||Primarily in marketing, providing consumers with more accurate interest rate charges for side-by-side comparisons between lenders|
|What’s the difference?||Interest rate reflects the rate that loan payments are calculated on based on the gross (before loan fees) amount of the loan||The effective interest rate a borrower pays based on the net (after loan fees) loan amount received|
|What fees are included||N/A||Fees charged that are related to obtaining the loan itself|
|What fees are excluded||N/A||Generally, fees incidental to the purchase of the item financed, but not to the loan itself|