When it comes to evaluating any loan you are interested in or for that matter even a line of credit, there are a few important things to consider, and many people new to loans often get confused on one key point. The key point many people get easily confused on is the difference between the interest rates advertised and the annual percentage rate or APR. Your advertised interest rate, otherwise known as your nominal interest rate is used to calculate the interest expense of your loan. For example if you took out a loan of $100,000 with a 6.5% interest rate, then your annual interest cost would be $6500 per year with a monthly payment of $650.
APR now is different. Your APR is expressed as a percentage rate and your APR will include not just the interest rate but also every fee and expense associated with the loan. Your APR will always be equal to or greater than your nominal interest rate with one exception. The exception to this rule is when your lender is offering you a rebate on a certain portion of your interest expenses. Using our past example of the $100,000 mortgage loan, the APR will be vastly different. You have closing costs, mortgage insurance costs as well as loan origination fees totaling $4000. If you want to figure out your mortgages APR you will add in these fees to the original loan amount of $100,000 to create a new loan amount totaling $104,000. The 6.5 percent interest rate is used on this new figure to calculate your new annual payment of $6760 with a monthly cost of $563.33 Now to calculate the APR you divide the annual payment of $6760 by the original loan amount of $100,000 to get an APR of 6.76%
When you want to compare two loans you want to compare the nominal rate first. Why look at the nominal rate first? The lender who offers the lowest nominal rate is very likely to offer the best value due to the majority of the loan being financed at a lower rate overall, even after fees are accounted for. What can be confusing is when you see the same nominal rate between two lenders but differing APRs. The lender with the higher APR is simply charging you more fees and the one with the lower overall APR is offering you the better deal. The one with the lower APR is the better deal since they are requiring fewer fees.
There are some things to consider about the APR however. For one using the APR to calculate the true costs of say an adjustable rate mortgage can be difficult as no one can predict the future interest rates and directions that interest rates may go. Another fact to consider is that lender costs are spread out through the entire lifetime of your loan so refinancing your home could be more expensive than what is suggested by the APR.
When taking out any loan be sure to compare each lenders listed APR and nominal interest rate. The Federal Truth in Lending Act requires that all loans list both the APR as well as the nominal interest rate so this is a very effective tool to determine the true cost of any loan you are pursuing. Using this tool can help you avoid lenders charging excessive loan origination fees and save you a great deal over the lifetime of any loan you take out. The more you understand about any loan you plan to take out, the more informed you can be about getting the best deal available.