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Confusing terms in loan applications sometimes make it difficult to choose the right deal Image Credit: Corbis

Dubai: When you’re refinancing or taking out a loan, keep in mind that an advertised interest rate isn’t the same as your loan’s annual percentage rate (APR).

Difference between APR and interest rate
Both terms ‘annual percentage rate (APR)’ and ‘interest rate’ refers to the rates of interest charged to borrowers, or simply put, it is the cost you pay each year to borrow money. Both are expressed as an yearly percentage rate.

However, while APR is the annual cost of a loan to a borrower — including fees, when referring to ‘interest rate’, this does not include fees charged for the loan.

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The APR is intended to give you more information about what you’re really paying. Most regulations worldwide require every consumer loan agreement disclose the APR.

Since all lenders must follow the same rules to ensure the accuracy of the APR, borrowers can use the APR as a good basis for comparing certain costs of loans. However, keep in mind that your monthly payment is not based on APR, it's based on the interest rate.

Let’s illustrate with an example

When you’re shopping for let’s say, a home loan, you’ll see lenders advertise their best mortgage interest rate versus the APR, or annual percentage rate. They’re required to show you both rates, because APR gives you a sense of the lender’s fees in addition to the interest rate.

As a borrower, you need to know if a lender is making up for a low advertised interest rate with high fees, and that’s what the APR can tell you. If the APR is close to the interest rate, you’ll know that the lender’s fees are low.

This article details how lenders use APR, compared to the ‘interest rate’, and how you can use your new understanding of these terms to save money on your loans.

Even if you already understand how APR works from your experience with credit cards and vehicle loans, there’s a lot you may not know about how APR works for loans.

When you borrow money to buy a home or a car, you pay interest. When you lend money, you earn interest. If you have a savings account or certificate of deposit, you’re lending money to a bank and they’re paying you a small return so you’ll have an incentive to put your money there.

APR vs. Interest Rate: Why these numbers matter to you

Since APR includes both the interest rate and certain fees associated with a home loan, APR can help you understand the total cost of a loan if you keep it for the entire term. The APR will usually be higher than the interest rate, but there are exceptions.

One exception is a no-closing-cost refinance loans, in which the interest rate and APR will be the same. Another exclusion is an adjustable-rate mortgage (ARM), a type of mortgage in which the interest rate applied on the outstanding balance varies throughout the life of the loan.

The APR for an ARM will sometimes be lower than the interest rate. This can happen in a declining interest rate environment when lenders can assume in their advertising that your interest rate will be lower when it resets than when you take out the loan.

However, the APR on an adjustable-rate mortgage is only an estimate, because no one can predict what will happen to interest rates over your loan term. Your APR on an ARM will only be known after you have paid off the loan.

Which loan is cheaper? Interest Rate versus APR

Let’s consider, compare and analyse instances of two loans. Consider, for instance, a loan of Dh200,000, with a 3.00 per cent fixed interest rate, Dh10,000 in fees and a 3.40 per cent APR – let’s call this Loan #1.

As Loan #2, let’s consider the same amount of Dh200,000 (the principal amount), offered at a 3.40 per cent fixed interest rate, incurring Dh4,000 in fees at a 3.56 per cent APR. At first glance, many would deduce that the second loan is more expensive, given the higher rates. But this is not the case.

Let’s next analyse how much each of those loans will truly cost you, at different time stages of the loans. Both loans have a term or loan tenure of 30 years.

When calculating costs three, five, seven, and 10 years into the loan, Loan #2 was cheaper than Loan #1, cost-wise – with a difference in costs ranging from Dh840 to Dh4,450.

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However, from the end of the eleventh year, up until the end of the tenure of 30 years, costs at the 15-year and 30-year mark were higher for Loan #2 – with a difference in costs ranging from Dh20 to Dh9,480.

Eventually, you might pay off your loan and clear it early, ideally before retirement—unless you’re happy to carry a low-rate mortgage so you can have extra cash to invest.

So, all the loan fees you pay should really be averaged out over, say, five years or however long you think you’ll keep the loan, not 15 or 30 years, to give you an accurate APR.

Key takeaway points

Both the APR and the interest rate are ways for consumers to comparison shop as well as determine the affordability of the loan. The interest rate is determined by prevailing rates and the borrower’s credit score. For instance, the higher your credit score, the lower your interest rate will be. Your monthly payment is based on the interest rate and principal balance, not the APR.

The APR, conversely, is determined by the lender, since it’s composed of lender fees and other costs that vary from lender to lender.

Especially when looking for a mortgage or home loan, the APR and interest rate are two of the most important numbers to consider, because even a seemingly small variance in rates can have a significant impact on your total costs.

One particular case study had showed that the average borrower could have saved Dh33,056 over a 30-year term, or more than Dh 1,101 per year, if they found the lowest rate at the time they got their loan.