Most people hear the terms APR, points and interest, and have a vague sense that they relate to a percentage applied to credit or loans. While each of these three terms do have some relation to the percentage of the principal amount in an outstanding loan, they actually measure very different and specific aspects of a payment. Knowing the difference between each of these terms and what they stand for can help you save money as a debtor and avoid rash spending choices.
The most basic concept is interest rate. The interest rate is defined as the cost of a loan to a borrower and is expressed as a percentage. The point of an interest rate is to ensure that the lender receives a return for the assets that they let someone borrow. In other words, you can’t borrow money for free, so you pay a percentage based on the amount you borrow as a fee to be able to use that money.
There are a number of different financial structures when it comes to interest. Simple and compound interest are the most common. Simple interest means that the amount owed in interest is only calculated based on the initial loan, and the payment amount is the same each payment period. So, if you borrow $1,000 at 3% interest, the amount you need to pay annually will be $30. Compounding interest means that interest is calculated based on the initial principal added to the accumulated interest each period. Let’s say you borrow $20,000 with an annual interest rate of 5% and pay it off over three years. The first year, the amount of interest you will pay is $1,000. Add that $1,000 to the initial principal, and the second year you will pay 5% interest on $21,000, which is $1,050. Add the interest from the second year, and the third year you pay 5% interest on $22,050. The ending total of what you’ll pay is $23,152.50.
There are also market-dependent interest structures that form the basis for variable and fixed interest rates. A fixed interest rate simply means that the interest rate does not change. A variable interest rate means that the debtor and lender agree to have interest-rate calculations change to follow the market interest rate, which can lead to either increases or decreases in that rate.
The biggest mistake people make with APR is assuming that it means the same thing as interest rate. While APR is also expressed as a percentage, it’s a value that takes into account other factors associated with a loan. APR was introduced to consumers as a part of the Federal Truth in Lending Act of 1968, which sought to help consumers make informed decisions in purchases involving credit and loans.
Let’s take mortgages as an example. The interest rate is only a representation of the costs associated with your purchase of the house. Thus, a 5% interest rate on a $300,000 house reflects an annual cost of $15,000 in interest. However, when you buy a house you’re likely to incur quite a number of additional fees along with the purchase, such as mortgage insurance, closing costs, discount points and loan origination fees, which will result in you spending more money. Let’s say those extra fees amount to an extra $10,000 you need to pay.
The APR is a way to represent that extra $10,000 in cost through a percentage. With the fees, your total loan amount will be $310,000. Five percent of $310,000 is actually $15,500 instead of $15,000. We divide the adjusted interest rate of $15,500 by the initial $300,000 needed to make the purchase to get around 5.17% for APR. The APR is usually higher than the interest rate because it factors in these extra costs.
The APR is intended to help you make informed decisions when comparing different loans. You might have two loan options at 5% for $10,000, but one has an APR of 5.05% and another has an APR of 5.30%. The loan with the higher APR has more hidden costs and fees associated with it. It’s also important to note that an APR is accurate only if you decide to make payments over the entire loan period.
A point is distinct from the interest rate because a point is usually linked with a payment a debtor can make to reduce the interest rate. A point is equivalent to 1% of the principal amount, so paying a point on a $250,000 loan would mean paying $2,500. Depending on the circumstances of the loan, a lender may choose to offer a debtor the ability to pay anywhere from zero to four points to reduce their interest. Paying a point can reduce the interest rate anywhere from an eighth to a quarter of a percent.
If you have any questions regarding these concepts, don’t hesitate to reach out to our Funding Specialists at Currency. We’re always available for a call at 877-358-4595, and would love to answer your questions and guide you toward the best option for your business.