When you look to take out a loan of any nature, you’re likely to hear two phrases come up in conversation with your lender or real estate agent: “APR” and “interest rate.” It is important to understand the difference between interest rates, also known as nominal rates, and APR, or annual percentage rates. Both of these figures have to do with how much you will end up repaying over the span of your loan until it is paid in full.
Our friend, a North York Mortgage Broker offered some valuable intel, read on to learn how interest rate differs from APR and what you should know before obtaining a loan.
What is an Interest Rate?
A simple interest rate, also often referred to as the “nominal interest rate,” is calculated on the principal of the loan only. A loan of $100,000 with 5% nominal interest would require $105,000 being paid back to the lender. Nominal interest is a flat rate that is easily calculated, and is typically less than or equal to the APR on a loan.
What is APR?
APR stands for “annual percentage rate,” but is also known as the “effective interest rate,” and sometimes “compound interest.” Essentially, the amount paid toward the APR reflects not only the loan itself, but any additional costs that were accrued to obtain the loan in the first place (like mortgage insurance and closing costs). For instance:
If you were to take out a loan of $100,000 with a 5% interest rate on a loan, you end up paying back $105,000. Your APR, however, compounds the interest accumulated by the loan and its related costs for a total of $105,062.50 that needs to be repaid. APR is typically higher than or equal to nominal interest rate.
Canadian lenders are required to quote the APR to those seeking a loan through their institutions.
When is the APR Lower Than the Interest?
As stated above, the annual percentage rate paid on a loan is typically higher than or equal to the nominal interest rate. This is not always true, however, as lenders may offer special rebates on portions of your interest. There are very few scenarios wherein the APR offered by a lender will be lower than the nominal interest.
Many borrowers feel stumped when they find banks offering the same interest rates on the same amount, but different APRs. When these circumstances arise, it is good practice to go with the lender that is offering the lower APR. Lower APR means that the lender is asking for less upfront costs. It’s just a better deal.
APRs can be a bit more complicated than the information above might lead you to believe. This is especially true of adjustable-rate mortgage loans where interest rates are expected to fluctuate. Because the APR is spread over the course of the duration of the loan, it is ineffective at accounting for changes to the interest rate. It is for this same reason that when you attempt to refinance a house, it could be more expensive than your APR initially indicated.
When you understand the difference between APR and nominal interest rates, you will be able to make the best decisions in relation to choosing your lender.