Humans have a natural tendency to portray themselves in the best possible light. When the neighborhood kid who mows the lawn wants more money, he says his rate is lower than what the other kids are charging. When he gets together with the other kids, he brags about getting paid 20 percent more for the same amount of work.
Consumer credit companies, including mortgage lenders, are no different. When they’re lending you money, they like to talk about their low APR, which stands for Annual Percentage Rate. When they’re “borrowing” your money (by selling you a CD at the bank, for instance) they advertise their generous APY, which stands for Average Percentage Yield.
APR is the term relevant to mortgage borrowers. But it’s useful to understand both, as well as a third concept—compounding.
When you’re paying a simple interest loan at a rate of, say, 12 percent per year, it’s easy to calculate its effect per month. It’s 1 percent. At that rate, a $10,000 debt balance increases by $100 each month or $1,200 each year.
Enter the “magic” of compounding. Einstein called it “the most powerful force in the universe.”
For the lender, the magic works this way. After one month, your new balance is $10,100. At that point, the lender starts charging interest not on $10,000 but on the new balance of $10,100. After a year (if you’ve made no payments) your balance is $12,268. Your simple interest rate was 12 percent but your APR worked out to 12.68 percent.
In fact, for the borrower, it’s worse than that. Lenders don’t compound monthly—most do it daily. That’s the significance of the “daily periodic rate” you see listed at the bottom of your statement. The above 12.68 percent APR becomes something like 12.74 percent. (In a periodic rate, more “periods” means more interest.)
There is more you should know about APR. InvestorWords.com defines it as “the yearly cost of a mortgage, including interest, mortgage insurance, and the origination fee (points), expressed as a percentage.”
The add-ons are man-made, not mathematical constructs. But clearly, they’re of interest to borrowers when cross-shopping loan rates between banks. Just be sure the same number of points is factored into both figures, or you’re comparing an apple to an orange.
Hey, what about APY? Again, that’s more relevant when you’re the lender. Buy a 12-month CD and the bank will advertise its great Annual Percentage Yield of 1.4 percent – which sounds a little better to you than the APR, which is 1.3-something. Hence, the magic works in your favor for once.
A related note comes from the Lessons for Life Department. Given a choice, be a lender, not a borrower. Better yet, be a bank.