Terms Borrowers Should Understand – Interest Rates & APRs

If you are new to buying a house, borrowing or have made some mistakes when in the financial market, you might consider learning the lending terms. You hear the words interest rates and APRs and usually your first instinct is to nod you head and think, “whatever”, because ultimately you need the money. However, interest rates and APRs have a major impact on the loans we take out and can also affect our ability to pay back our obligations. Therefore, if you are considering working with a creditor, read up about the details of interest rates and APRs so you can be an educated borrower.

For many people, we assume that interest rates and APRs are the same thing, because both of them charge us money. Yet, on the contrary, interest rates and APRs are quite different and they will definitely impact the loan you take out and even your ability to pay it back. For this reason, it is imperative to understand the difference between to two so you know what you are getting yourself into.

Typically, we understand interest, because it is the fee we incur for borrowing money. When it comes to a mortgage, your interest rate is typically determined by the amount of principal you pay and the term of the loan. However, depending on the different types of loans and how much you borrow, the interest will vary with the loans.

There are specific factors that affect interest, one being the type of loan that you take out – is it a fixed loan, and ARM loan, etc? Also, the amount of interest you pay on your home mortgage takes into consideration the amount of your loan versus the value of your home. Lastly, interest is evaluated based off the type of property you are purchasing – is it for your primary residence, a second home, or an investment property?

One of the great things about a mortgage is that you can actually “buy down” the interest rate if you want to. You “buy down” your interest rate by paying points up front. A point usually equals 1 percent of the loan you are buying, so if your loan was $ 100,000, you could “buy down” five points in interest by paying $ 5000 dollars up front. Buying down is a great way to not only reduce the interest rate, but also reduce the amount you will pay in the long run, and there are actually possible tax benefits from doing so.

If you do not know how to calculate interest, it is actually quite simple. You divide the total amount of interest charged from the loan by the total amount of the loan; therefore, if your lender loans you $ 10,000 and charges you $ 100 in interest your interest rate is (100/10000) x 100 percent = 10 percent. Computing interest rates always simple, even if the numbers are a little bit more complicated.

Besides the interest rate, APR (annual percentage rate) is also discussed frequently when it comes to lending. The APR is calculated annually and it includes the total closing costs and interests over the entire term of the loan; therefore, many believe that it is a better indicator of the expected costs of the loan. When you look APR, you tend to overlook costs that may come up in the future.

Because the APR takes into consideration all of the costs, not just the interest rate, it is usually higher than the interest rate. Also, the calculation for APR is not as simple as calculating interest, because it involves an amortization schedule and a more complex equation. For this reason, the APR is often a better prediction about your future charges from the loan.

When you do apply for a mortgage, do not be surprised when both the interest rate and APR are discussed. The rates will definitely vary given you credit score and the conditions of the market. Yet, those who better understand the terms will make more informed decisions when it comes to borrowing.

While interest rates and APRs are definitely based on the market, the controlling costs that come with a new mortgage are definitely something that you have control over. These items are the prepaid items such as the closing costs and mortgage insurance. Work with your lender to negotiate these items, especially given that you have more flexibility with them.

Lastly, now that you are more informed, do not jump the gun and go with the first offer. Shopping around is always wise. Find the lender that best fits you.