Interest rates are one of the most important and tricky terms when it comes to procuring loans. Banks consider your monthly income, loan amount required and the repayment period of the loan before deciding the interest rate. It is very important to know how the interest rate is calculated and the difference between the Annual percentage rate (APR) and Interest rate, before comparing and deciding on a loan.
When a bank quotes a rate, it is quoting the APR. The primary difference between the two is that the interest rate conveys what amount you’re required to pay monthly and whereas APR is the total cost of borrowing.
APR vs Interest rate
The APR is the summation of the interest rate as well as all the other fees associated with the loan. Due to this, the APR seems more than the nominal interest rate of the loan.
Fees usually included in APR ( may vary bank to bank)
- Origination fees (fee charged by a lender on getting into a loan agreement to cover the cost of processing the loan), discount points (amount paid in lump sum at the beginning to decrease the interest rate)
- An administration fee, such as documentation fee, underwriting fee.
- Closing cost/fees
- Prepaid interest (day/tenure affects this)
Fees that are not included in the calculation of APR (may include or exclude any other fee)
- Appraisal fee
- Credit report fee (credit score report)
On the other hand, an Interest rate is levied on the borrowed amount alone, it does not take into consideration any other costs associated with the loan.
To make things clearer, here is an example:
Let’s say you apply for a mortgage loan in UAE of AED 300,000, the interest levied on the loan is 6%. Then your annual interest amount would be AED 18,000 or a monthly charge of AED 1500. Now let’s assume there are other cost/fees associated with the loan, such as closing fee, procedure handling fee, broker fee, and all this cost comes up to AED 5000. In this case, your principal amount becomes AED 305,000, the 6% interest rate will then be AED 18,300 and APR would be 6.1% ( dividing the new annual amount i.e 18300 by the original principal amount of 300,000) for one year.
The calculation of APR of different loans differs, hence it is advisable that the comparison of it, is done amongst similar products only.
Interpretation
Since APR takes into consideration all the cost associated with the loan, unlike interest rate, it is considered as the true cost of the loan. Hence, whenever you shop for a loan, it is advisable that you compare the APR quoted by different banks along with the interest rate. The APR might vary due to reasons such as high or low upfront fees. the latter is considered favorable as the upfront fee that you’re going to pay is assumed to be paid over the life of the loan just like the interest rate.