APR and Interest Rate: Understanding The Difference
When it comes to borrowing money, two terms that often confuse people are APR (Annual Percentage Rate) and interest rate. While they might seem similar, they have subtle differences that are important to understand.
Defining Interest Rate
The interest rate, also known as the advertised rate or nominal rate, is essentially the cost of borrowing the principal loan amount. It is expressed as a percentage and does not include all the fees you’ll pay for the loan. For instance, if you were to take out a mortgage for $450,000 with a 5% interest rate, your annual interest expense would be $22,500, or an average monthly interest of $1,875.
Interest rates can be influenced by various factors, including the Bank of Canada’s key interest rate. This rate is the rate at which major financial institutions borrow and lend one-day (or “overnight”) funds among themselves; this rate influences the interest rates that banks offer to consumers.
During periods of economic downturn, the Bank of Canada may lower the key interest rate to stimulate spending and investment. Conversely, during periods of strong economic growth, the Bank of Canada may raise the key interest rate to curb inflation. They can also be influenced by the financial markets, like the movement in the yield of bonds, this is what influences the fixed-rate mortgages.
APR: Beyond the Interest Rate
The APR (Annual Percentage Rate) is a more complete way of measuring the borrowing costs. It includes not only the interest expense on the mortgage but also all fees and other costs involved in procuring the loan. These fees can include broker fees, closing costs, appraisal fees, sometimes legal fess, etc. This makes the APR a more effective rate to consider when comparing loans or mortgages. The APR should always be greater than or equal to the nominal interest rate. Lenders are required to provide the APR for credit products to potential borrowers. This helps borrowers understand the total cost of a loan if they keep it for the entire term.
In Canada, some fees are excluded from the APR, such as mortgage prepayment penalties and CMHC mortgage insurance premiums. Some lenders might try to entice borrowers with a low interest rate but high fees, but looking at the APR can allow borrowers to see how much it will really cost.
Interest Rate vs APR: A Practical Example
Let’s consider two mortgages, both for $450,000. The first has an interest rate of 5%, and the second has an interest rate of 5.5%. At first glance, the mortgage with the 5% interest rate seems like the better deal. However, the true cost of the loan isn’t just the interest rate. Once we add the other costs to the mortgage, the numbers will give us the true cost of borrowing. So, if the 5% loan has substantial fees and costs associated with it, its APR could be significantly higher than that of the 5.5% loan. So to simplify, the interest rate represents only the cost of borrowing the principal amount, while the APR reflects the interest rate plus any additional costs that may apply to your mortgages. This makes the APR a more effective rate to consider when comparing mortgages.
Caveats to APR
While APR is a useful tool for comparing different mortgage offers, it has several caveats.
Firstly, APR does not account for compounding. It is calculated on an annual basis, but interest on mortgages can compound daily, monthly, or quarterly. This means the effective annual rate (EAR), which considers compounding, can be higher than the stated APR.
Secondly, APR does not include all fees. While it includes interest costs, it may not include all the fees associated with a mortgage, such as Legal Fees and Home Inspection Fees. These fees can add to the cost of borrowing.
Thirdly, Variable APRs can be unpredictable. For variable-rate mortgages, the APR can change over time with market conditions, making it difficult to predict the total cost of the loan.
Fourthly, Introductory APRs can be misleading. Some lenders offer a low introductory APR that increases after a certain period. If you’re not aware of when the APR will increase and what it will increase to, you could end up paying more in interest than you anticipated.
Other considerations include mortgage prepayment penalties and mortgage default insurance.
Understanding the difference between APR and interest rate can help you make more informed decisions when it comes to borrowing money. Always remember to consider both rates when evaluating loan options. If you have any questions or need further clarification, don’t hesitate to reach out to us at TheBroker.ca Ltd., through our website or call us at (519) 252-9665. We’re here to help!
Please note that this article is intended for informational purposes only and should not be considered financial advice. Always consult with a financial professional before making any major financial decisions.
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