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The Difference Between APR and Interest Rate

Interest rate

When you get any sort of loan, you are going to see terms like "interest rate" and "APR." Many of us treat these terms as virtually identical, but the truth is that they are different in subtle ways. Understanding these difference can give you greater insight into what you are really paying when it comes to your various debts.

APR vs. Interest Rate with Your Mortgage

The interest rate is the nominal cost, expressed as a percentage, of borrowing money. Your mortgage rate is just the number used to let you know how much the loan will cost. However, the interest rate you are quoted on your mortgage doesn't usually include all of the fees and other costs associated with your loan.

With a mortgage, you want to be more concerned about the annual percentage rate (APR). The APR on a mortgage is a broad expression of the total annualized cost of borrowing the money. Included in the APR are your points, closing costs, broker fees, and other costs as well as your interest rate. The APR is more inclusive.

The government has laws governing how the APR is determined, and this is the number you should look at when comparing different mortgage terms. You do need to be careful about comparing adjustable-rate loans, though. The APRs on adjustable-rate loans won't reflect future changes, so it's important to understand what could happen in the future with an adjustable-rate loan. In many cases, it makes more sense to stick with a fixed-rate mortgage so you always know what to expect.

Since the APR on a mortgage includes several other costs, it should be higher than the loan's interest rate. The only way this wouldn't be the case is if the lender is rebating some of your expenses. Make sure to ask questions if you see something that doesn't seem quite right.

APR vs. Interest Rate with Credit Cards

It's also important to understand what an APR is when it comes to your credit card interest rate. The APR is the interest rate you are charged on an annual basis. However, the APR doesn't account for what happens when interest is compounded on a monthly or daily basis.

With your credit card, the interest rate you really want to consider is the APY, or annual percentage yield. With a credit card, the APR is the base rate, while the APY takes into account any compounding. As you know, once you start compounding (or charging interest on your interest), the "real" interest rate starts rising.

The formula for figuring out the APY is (1+(r/n))n – 1, where r is the stated interest rate, and n is the number of times the interest compounded during the year.

Consider a credit card with a rate of 15.99% that is compounded monthly (or 12 times per year). The APY would be about 17.22%. And what about interest that is compounded daily? Now you're looking at an APY of 17.33%.

That changes things a little bit. When performing calculations based on APR, you might assume that you would pay $159.90 in interest on $1,000 for the year. However, if your interest is compounded daily, you are actually paying $173.30 for the year. That's $13.40 more, due entirely to the way your interest is compounded!

When reading the fine print on a credit card offer, make sure you look for the APY, since the APR is the number that creditors like to emphasize.

Once you know how different interest rates are figured, you are better prepared to make decisions about your finances.

Miranda Marquit is a professional freelance writer who specializes in personal finance topics. She enjoys writing about saving money and paying off debt at the ReadyForZero blog and also writes for her own blog. She lives near Salt Lake City. You can follow @ReadyForZero and @MMarquit on Twitter.

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