Articles and Opinions

Understanding APR

M Sanchez

August 22 2023

Annual Percentage Rate

The annual percentage rate (APR) is the total cost of the loan. It includes interest rates plus other costs. The biggest cost is usually one-time fees, called "points." The bank calculates them as a percentage point of the total loan. The APR also includes other charges such as broker fees and closing costs.

Both the interest rate and the APR describe loan costs. The interest rate will tell you what you pay each month. The APR tells you the total cost over the life of the loan. Use the APR to compare total loan costs. It's especially helpful when comparing a loan that only charges an interest rate to one that charges a lower interest rate plus points.

The APR calculates the total cost of the loan over its lifespan. Keep in mind that few people will stay in their house with that loan, so you also need to know the break-even point, which tells you at what point the costs of two different loans are the same. The easy way to determine the break-even point is to divide the cost of the points by the monthly amount saved in interest.

In the example above, the monthly savings is $39. The points cost $4,000. The break-even point is $4,000 / $39 or 102 months. That's the same as 8.5 years. If you knew that you wouldn't stay in the house for 8.5 years, you would be better off taking the higher interest rate. You'd pay less by avoiding the points.

The Bottom Line!

Interest rates affect how you spend money. When interest rates are high, bank loans cost more. People and businesses borrow less and save more. Demand falls and companies sell less. The economy shrinks. If it goes too far, it could turn into a recession.

When interest rates fall, the opposite happens. People and companies borrow more, save less, and boost economic growth. But as good as this sounds, low interest rates can create inflation. Too much money chases too few goods.

The Federal Reserve manages inflation and recession by controlling interest rates, so pay attention to the Fed's announcements on falling or rising interest rates. You can reduce your risks when making financial decisions such as taking out a loan, choosing credit cards, and investing in stocks or bonds. Interest rates affect your cost of borrowing money. Always compare interest and APR when considering a loan product.