If youâ€™re in the market for a mortgage, car loan or considering a different credit card, you pay attention to the low rates advertised. Interestingly though, itâ€™s never mentioned what kind of rate the ad is referring to: the basic interest rate or the annual percentage rate (APR).
Only one rate tells the full story of how much borrowing that money will cost you. Itâ€™s the APR.
Hereâ€™s the difference:
- Interest rates reflect the cost you pay each year to borrow $25,000 for a car or $100,000 for a home. Itâ€™s a percentage of that principal and itâ€™s determined by many factors, namely how much it costs the lender to borrow money from the Federal Reserve, as well as your credit score.
- APRs represent the real cost to you in repaying the required amount each year. This rate includes the interest rate on the principal (above) plus any extra interest and fees charged by the lender. Unlike the interest rate, APR is determined by the lender.
Fortunately for consumers, a 50-year-old law called the Truth in Lending Act requires all lenders to disclose the APR in any consumer loan contract. That makes it easier to quickly compare loans and credit card offers. But only if you know the difference between APR and interest rates and what it means to your bottom line.
A tiny percentage point difference can mean thousands of dollars over the life of a loan. Itâ€™s especially true with mortgages. APR can work for or against you, depending on how long you plan to keep the house. Generally speaking, the lower the interest rate, the lower the APR, and the more points and fees will be associated with the loan.
What are â€œpoints,â€ anyway? Theyâ€™re reductions in your interest rate, but you have to pay for themâ€”up front. They pay for themselves over time or cost you in the short term. Take for example a $200,000 loan with three different interest rates and APRs
|Points and fees||$8,800||$5,800||$2,800|
|Total costs, 3 years||$43,174||$41,220||$39,281|
|All costs, 10 years||$123,380||$123,866||$124,404|
|All costs, 30 years||$343,739||$354,197||$367,613|
(data courtesy of Bankrate.com)
If youâ€™re planning to be in a home for five years or less, a lower APR can actually cost you more than an interest rate a full three points higher!
The Credit Card Balancing Act
If you pay off your credit card balances every month, you should be more concerned with the points or miles you can earn with various cards rather than the APR. If you regularly carry a balance, or are considering transferring it to another card account, pay close attention to APR.
Actually, there are several different APRs to evaluate, and some can change from day to day:
Introductory: You might see a 0 percent APR or something close to it advertised in a mailer or online. Banks entice new customers this way, yet the rates are typically good for only a set time. Find out what the APR is once the intro period expires.
Balance transfers: If youâ€™re moving your balance from one card to another, determine what percentage of that balance is included in the APR.
Purchases: This is the most important APR to monitor. Purchases made on the card usually make up the bulk of the balance, and the interest paid on them will be higher than any introductory or balance transfer APR, currently 16 percent on average.
Cash Advances and Late Fees: Banks and credit card companies treat these differently than purchases or balance transfers. The APR will be higher on these portions of your balance, sometimes as high as 30 percent.
As they do with mortgage loans, interest rates do impact the APR on your credit card debt. Again, however, APR is the rate that ultimately matters. There often are multiple APRs tied to a credit card account, and theyâ€™re always going to be higher than the APR on a mortgage. With that in mind, pay down credit card balances before putting any extra payments toward your mortgage. Â
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