Annual Interest Rate vs Interest Rate: What’s the Difference? Is it important to know? How do lenders calculate both? Which one should I use? These are all great questions.
I have a good news! This post aims to introduce you to interest rates and annual interest rate, their differences and how they are calculated.
The basics:
Interest rate is a general term for loans and lines of credit, and understanding how it works is a relatively straightforward task. What about the annual interest rate?
Annual interest rate is another common term in finance, but many people do not understand its meaning, how it differs from the interest rate, and its effect on borrowing money.
Understanding the annual interest rate of a loan or line of credit is a must as it gives you a general idea of how much such a loan will cost you in the long run.
With this brief introduction, let’s get down to business.
Annual interest rate versus interest rate
Interest rate
The nominal interest rate, or declared rate, refers to the interest you must pay over a specified period in order to borrow money from a lender. The interest rate is presented as a percentage and can be fixed or variable. Although the interest rate can be set for any period, it is usually expressed as an annual rate.
For example, you are borrowing $ 3,000 at 5% per annum for 12 months. At the end of 12 months, you will end up paying $ 150 in interest, bringing your total to $ 3,150 ($ 3,000 in principal + $ 150 in interest).
Many factors can affect the interest rate you receive from a lender, including but not limited to the general economy, financial markets, debt-to-income ratio, credit rating, and the amount you contribute as a down payment. Your debt-to-income ratio and credit rating play an important role in determining what is called your credit worthiness.
Interest rates can vary widely depending on the type of loan or loan you are trying to obtain and the factors discussed above. These can range from 0% (usually advertised for some vehicles, household appliances and other items as a means of attracting customers) to 30% + for personal loans to people with poor creditworthiness.
It is important to know the interest rate on the loan. Not only to decide whether to take out a new loan, but also to draw up a plan to pay off existing debt using strategies such as Debt Snowball and Debt Avalanche.
Variable and fixed interest rate
Interest rates can be fixed or variable.
The fixed interest rate will never change, regardless of whether external factors that usually affect interest rates, such as financial markets, change. Thus, with a fixed interest rate, your interest rate remains unchanged for the entire term of the loan.
On the other hand, the variable interest rate can change over the life of the loan. This is because variable interest rates are tied to an index rate, and if that index rate changes, so does your interest rate.
Annual interest rate
The annual interest rate or annual interest rate includes the interest rate on the loan and all other related costs such as commissions, closing costs, discount points, etc.
Like the interest rate, the annual interest rate is also expressed as a percentage, and in most cases it should be the same or higher than the interest rate.
Let’s use the same example we used above for interest rates:
You borrow $ 3,000 at 5% per annum for 12 months. The lender will charge you a fee of $ 30 to process the loan. After 12 months, you will be required to pay a total of $ 3,180 ($ 3,000 in principal + $ 150 in interest + $ 30 in commission). In this case, the annual interest rate is 6%.
The annual interest rate gives you a complete picture of how much it costs you to borrow money. However, when comparing loans, it is important to consider both the interest rate and the annual interest rate.
The fees associated with granting a loan depend on what type of loan you are applying for. Some of the more common ones are:
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- Application Fee: Some lenders only charge a loan application fee and you are responsible for it, whether you qualify or decline.
- Loan Processing Fee: A fee intended to compensate the lender for the work required to obtain the loan.
- Handling Fee: A general term for any additional fees, many of which are negotiable.
- Document Fee: A fee designed to cover the effort required to prepare loan documents.
- Underwriting Fee: A fee charged to cover the costs of the underwriter, the person who reviews the loan application and makes the final decision on the loan.
- Dealer Preparation: An additional commission usually added by dealerships when obtaining a car loan.
To expand this concept even further, credit cards can have several annual interest rates, and it is important to know about them and understand their difference:
- Initial annual interest rate: A rate assigned for a temporary period, usually to attract customers. After the initial introductory annual income has ended, there is regular annual income per purchase.
- Annual Percentage Rate Per Purchase: The regular rate you charge for a balance carried over month after month.
- Annual penalty rate: The rate your credit card company can legally raise if you exceed your credit limit or fail to meet your payments.
A bit of APR history
In the early 20th century, bankers and lenders could charge any interest rate they saw fit, as there were no rules. This often meant an average of 10% for mortgages and up to 500% per annum for private loans. In many cases, lenders use lower interest rates as bait, but the high fees are hidden and not communicated to consumers in advance.
The Credit Truth Act (TILA) was passed as a federal law in 1968 to protect consumers when dealing with lenders.
One of the most significant changes made by TILA was information that lenders had to disclose to consumers, such as the annual percentage rate (APR), loan terms, and the borrower’s general expenses. This information must be provided to the borrower in advance before signing any document, and in some cases on recurring accounts.
How lenders calculate the interest rate
Lenders calculate your interest rate using your details. Each lender has a different formula for calculating the interest rate, so you will most likely receive five different rates from five lenders.
While you do not have much control over the actual interest rate given to you, there are things you can do to improve your creditworthiness and thus improve the interest rate that lenders are giving you. These include your credit rating and your debt to income ratio.
- Credit rating: A number in the range of 300 to 850 that immediately tells lenders how well you are handling your loan. Many factors affect the calculation of your credit scores, such as payment history, credit utilization, length of credit history, new credit, and credit structure.
- Debt to Income Ratio (DTI): This is the percentage of your gross monthly income linked to debt. This shows lenders your ability to manage your monthly payments on any new debt you plan to acquire. A DTI of 35% or less is considered good, in some cases, such as a home loan, this number is around 43%.
- Government Secured Loan: An additional way to lower the interest rate is to use government backed loans such as VA, FHA, or USDA loans. They are insured by the federal government and usually have a lower interest rate than conventional loans.
How Lenders Calculate the Annual Interest Rate
When it comes to the annual interest rate, things are a little different, and unfortunately, you have less control over it as your lender controls all of the fees, which, together with your interest rate, make up your annual interest rate.
However, one of the things you can do to bring down your annual interest rate, at least when it comes to getting a home loan, is to make at least a 20% down payment. This will allow you to avoid private mortgage insurance (PMI) and, in turn, lower your annual interest rate.
Alternatively, you can lower your annual interest rate simply by negotiating lender fees or buying discount home loan points.
- Discount Points: Discount points allow you to buy “points” in exchange for a lower interest rate. You exchange a higher prepayment (payment of points) for a lower monthly payment, which saves you money over time.
Annual interest rate versus interest rate – which one to use?
So now you understand what the interest rate and the annual interest rate are. But which one to choose when comparing loans? Unfortunately, the answer depends on the circumstances.
Although the annual interest rate gives you a general idea of how much a particular loan will cost you, a lower annual interest rate does not necessarily mean that the loan is better for you.
For this reason, it is always important to consider both the interest rate and the annual interest rate on the loan. As part of this equation, knowing or evaluating whether you will pay off the loan early or not makes a difference.
In some cases, such as a mortgage, a loan with a higher annual interest rate and lower fees can be cheaper if you keep the loan for a shorter period, which means that you will either pay off the loan early or end up refinancing or selling. borrowed asset. …
As a general rule:
- If you plan to keep the loan for the entire term of the loan, then a simple comparison of APRs from different lenders can tell you which loan will cost you less over time.
- If you plan to pay off the loan earlier, you cannot simply use the interest rate or the annual interest rate when comparing loans. A loan with a higher interest rate and annual interest rate, but with a lower commission, may cost you less if you keep it for a shorter period.
This scenario occurs because you are primarily paying commissions on the mortgage initially, and thus the interest rate does not play a significant role until the loan is obtained.
What if you have the money to pay for something in advance? Take a loan for this or pay in full? An understanding of the so-called alternative cost can answer this question.
Conclusion
Knowing the interest rate and the annual interest rate on a loan is essential when comparing multiple loans or simply when deciding whether getting a loan is the right choice at all.
However, as we have learned, it is not as easy as choosing a lower interest rate or an annual interest rate. It is also important to understand the term of the loan and whether you plan to hold it for that period or not.
Having a complete picture of the loan you are considering taking out can enable you to make the right financial decisions, whether or not to borrow, pay off an existing loan earlier, or invest money instead.
And remember, there are things you can do to improve your creditworthiness and therefore the interest rate you receive from lenders. In addition, you can always discuss the lender’s commission and, in turn, lower the annual interest rate.
This post was originally published on Your Money Geek.