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Applying for a loan may seem complicated at times, especially with all of the different terms that are used. And depending on what kind of loan you take out, one of the most confounding pieces of the lending puzzle is figuring out the meaning of APR vs. interest rate.

Here's what you need to know about annual percentage rate (APR) and interest rate and how they affect your loans.

APR vs. Interest Rate: The Basics

Interest rate is a percentage used to determine your payment amount. If you borrow $100,000 at 5 percent with a fixed-rate loan, you'll pay interest equal to 5 percent of the principal balance over a year. The annual interest amount of $5,000 will be divided over your monthly payments. And as your principal balance decreases through amortization, or the process of making fixed payments on a consistent basis when paying off debt, this amount will also reduce slightly. In this example, the interest rate determines the payment, but it doesn't show the overall cost of the loan.

APR is similar to an interest rate, but rather than determining a payment amount, it informs the borrower what they'll pay each year for the loan, including loan-related costs. For example, many costs associated with a mortgage are paid at or before the loan closing. These costs are called closing costs, though not all closing costs are part of an APR. Costs that affect APR are considered finance charges.

Why the Two Percentages?

The point of APR and interest rate is to provide borrowers with a measurement of the total cost of a loan that's easy to understand. With these two rates, you can easily compare different lenders and loan products. Two lenders might be offering 5 percent fixed rate loans but one might have higher closing costs than the other. As a result, one loan may have an APR of 5.25 percent while another offers an APR of 5.15 percent. If you only look at the interest rate, you won't see the true cost of borrowing.

What Charges Are Included in an APR?

When evaluating APR vs. interest rate, it's important to know which prepaid finance charges will affect APR. These charges include:

  • Points: Discount and origination points are both types of prepaid interest that are most common in mortgage loans.
  • Loan Processing: This is a cost directly related to borrowing money. Personal loans, student loans, auto loans, and mortgages often have various application and processing fees that influence APR.
  • Settlement Fees: Common with mortgage loans, these cover the cost for a third party to conduct a loan closing.
  • Private Mortgage Insurance (PMI): This insurance protects a mortgage lender in the event of default.
  • Capitalized Interest: When a student loan is in forbearance, payments are on hold but interest continues to accrue. Once back in repayment, the APR will increase depending on how much interest is added back to the loan principal.

What Isn't Included in an APR?

An APR usually doesn't take into account the following costs:

  • Home Inspection: If your mortgage lender requires an inspection or an appraisal, it may relate to the value of the property and if it supports the loan amount or purchase price.
  • Transfer Taxes and Recording Fees: These taxes and fees you pay when closing on a home purchase are based on the property's sale price and have nothing to do with your mortgage.
  • Title and Lien Fees: Loans can have title-related charges such as lien searches or DMV recording fees that don't affect APR, but may be a borrower's responsibility.

Understanding the difference between APR and interest rate will help you make an apples-to-apples comparison of loans. Speak to a financial advisor to help understand your loan options and make the best financial decisions for your future.

This information and recommendations contained herein is compiled from sources deemed reliable, but is not represented to be accurate or complete. In providing this information, neither KeyBank nor its affiliates are acting as your agent or is offering any tax, accounting, or legal advice.

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