When you're looking through the complex jargon of loan agreement, you might come across terms that have you confused -- and curious at the same time.
The truth is:
There are different ways that lenders calculate interest charges.
That’s a result of lenders having different fees and different interest compounding schedules.
As a potential borrower, you might just look at the APR (annual percentage rate) and stick with the lowest interest rate.
But, we received the following question from an inquisitive reader:
When talking about loans, which is a better deal on a $10,000 loan (specifically referring to a credit card cash advance options)?
- 10.49% APR accrued monthly, with a Daily Periodic Rate of 0.028739%
- 3.99% APR accrued daily
The simple approach of choosing the lower interest rate makes sense here.
But the basic question of monthly or daily accrual becomes more significant when the interest rates are roughly the same.
What is APR?
Let’s start this analysis with the basic discussion of APR.
Once you understand what makes it up it’s easier to determine which interest accrual method will be the better deal.
It’s almost instinctive to look only at what’s known as the note rate, but that doesn’t tell the whole story.
For example, if you’re looking at two $10,000 loans, each with a five-year term, and one has a rate of 4.75% in the other 4.65%, you’ll probably go with the lower the two rates. But each is just a note rate – the nominal rate applied to the loan.
As strange as it may seem, it could well turn out that the higher loan rate has the lower APR.
And that’s why APR always matters.
It matters more than the published note rate.
That’s because APR is the effective rate that you’re paying on the loan.
Yes, all the loan documents will show 4.65%, or whatever the advertised interest rate is. But, the APR adjusts the rate to reflect certain costs associated with obtaining the loan.
Let’s say you take a loan of $10,000.
But, the lender also charges $300 in various fees, which might include an application fee, a credit report fee, and a doc prep fee.
Because of the fees, you’re not actually getting $10,000 in loan proceeds. When the cost of loan fees is deducted from the loan amount, you’re actually getting only $9,700.
- APR is the rate you’re paying on the loan when the note rate is applied to the net proceeds you’re receiving from the loan.
If the interest rate applied to a $10,000 loan is 5%, you’ll pay $500 in interest per year (to keep this example simple, we're going to ignore loan amortization here).
When the $500 in interest is applied to net loan proceeds of $9,700, the effective interest rate, or APR, is 5.155%, not 5%. The APR increases slightly to reflect the reduced net loan proceeds after the deduction of loan fees.
If you’re taking a loan that doesn’t involve the payment of loan fees, the note rate, and the APR will be the same.
That’s because you’ll receive the full $10,000 in loan proceeds.
Note rate vs. APR
At the opposite end of the spectrum, you can see significant differences between the note rate and the APR.
You can generally assume a typical mortgage will involve somewhere between 2% and 4% of the loan amount being paid in fees.
On $200,000 mortgage with 2% in fees, the net proceeds of the loan will be $196,000. If loan fees are 4%, the net proceeds will be $192,000.
The more you pay in loan fees, the higher the APR will be relative to the mortgage note rate.
Examples of fees that affect APR
Credit cards normally charge no upfront fee, though many do charge an annual fee that may be reflected in the APR.
Car loans typically charge no fees so the note rate and the APR will be the same.
Mortgage loans, however, tend to have a lot of fees and that’s why APR is probably more important with this type of financing than any other.
Examples of fees charged on mortgages that affect APR include prepaid interest, loan points, private mortgage insurance, application fees, credit report fees, and any other fees paid to the lender.
Ironically, not all closing costs are included in a mortgage APR.
For example, attorney’s fees are paid to a third-party and are not included in the APR.
Monthly vs. Daily Interest Compounding/Accrual
Now that we’ve covered the basics of APR, and why it’s different from the loan note rate, let’s get to the readers question.
To recap, here are the two scenarios the reader has been presented with:
- (A) 10.49% APR accrued monthly, with a Daily Periodic Rate of 0.028739%
- (B) 3.99% APR accrued daily
Once again, the second option, at 3.99% APR, is easily the better of the two deals since it’s well below the 10.49% APR of the first offer. If these are the only two loan offers on the table, the reader should absolutely select option B.
But let’s analyze the two.
For the 10.49% APR accrued monthly, the daily periodic rate of 0.028739% is the annual APR – 10.49% – divided by 365 days.
It’s interesting that the daily rate is being presented, given that the APR is based on a monthly interest accrual. Monthly interest is typically calculated by dividing the annual rate by 12 months.
In this case, the monthly rate would be 0.87417%. On a loan balance of $10,000, the interest due for the first month will be $874.17.
Since the 3.99% APR accrues daily, that’s actually where a daily periodic rate should be disclosed.
Since it wasn’t, we calculated the 0.010932%.
When applied to a loan balance of $10,000, the reader will pay slightly over $1.09 ($1.0932 to be exact) in interest per day, at least until the first principle payment has been made.
For a 30-day month, interest will be $32.80. But over the full year, it will come to $399. (Once again, we’re ignoring principal reductions to keep it simple.)
APR vs. Annual Percentage Yield (APY)
Any discussion of APR is also a good time to discuss its close first cousin, APY.
The main difference between the two:
APR refers to the interest paid on loans, while APY relates to interest received from interest-bearing investments, like savings accounts, money markets, and certificates of deposit.
With any such investment, there will be two interest rates disclosed – the actual interest rate paid on the deposit, and the annual percentage yield, or APY.
The difference between the two is the result of interest being accumulated on the interest already paid.
Higher APY is better
For example, let’s say you invest in a one-year $10,000 CD paying 2% interest. After six months, the CD has already accrued $100 in interest. Its balance is now $10,100, and the interest rate will be applied to that balance.
For that reason, the APY will always be higher than the stated interest rate of the deposit.
The above example is a dramatic oversimplification.
If the CD accrues interest on a daily basis, interest will be paid on the interest accrued beginning on day one. For this reason, a CD that advertises a rate of 2.37% might show an APY of 2.50%.
The difference between the two reflects the accrual of interest on the accumulated interest on the deposit.
If you ever get confused between APR and APY, just remember APR = loans, and APY = savings and deposits.