Difference Between APR and Note Rate

Key Difference – APR vs Note Rate

Both individuals and businesses apply for loans to fulfill capital requirements. Loans for capital projects and mortgage loans are common types of such loans. APR (Annual Percentage Rate) and Note rate are two important rates than should be considered before selecting a suitable borrowing option. The key difference between APR and Note Rate is that APR represents the actual costs of a borrowing, including the additional costs associated while Note Rate demonstrates the cost which is applicable for the borrowing alone, excluding other associated costs.

CONTENTS
1. Overview and Key Difference
2. What is APR (Annual Percentage Rate)
3. What is Note Rate
4. Side by Side Comparison – APR vs Note Rate
5. Summary

What is APR?

Definition of APR

An annual percentage rate (APR) is the annual rate charged for borrowing. It is the actual yearly cost of a fund borrowed over the period of that loan and expressed as a percentage. APR includes additional costs associated with the borrowing agreement; however, excludes the effect of compounding.

Calculating APR

Compounding is an investment method where interest received will continue to add up to the principal sum (original sum invested) and the following period’s interest is calculated not only based on the originally invested amount but based on the addition of principal and the interest earned.

E.g., assuming that a $2,000 deposit is made on the 1^st of January, at a rate of 10%, the deposit receives an interest of $200 for the month. However for the deposit made on 1^st of February at the same rate interest will be calculated not on $2,000, but on $2,200 (including the interest earned in January). The interest for February will be calculated for 11 months assuming that this is a one-year investment.

Borrowing agreements specify and include a number of other costs in addition to the cost of the loan. These include,

• Transaction Fees

Costs such as fees for processing the loan application and loan authorization fees can be categorized as transaction fees

• Late Penalties

If the borrower fails to fulfil the loan repayment obligations as per loan contract, a penalty for late payment will be applicable

• Cost of Early Repayment

The bank may grant the borrower the right to settle the loan before the original maturity date; however, there may be a charge from the bank to recover a part of the interest forgone as a result.

Due to the inclusion of the costs above, the APR is higher than the rate for the same loan.

E.g., Assume a loan is taken out for $300,000 at an interest rate of 6%. (Annual interest payment= $18,000).  The loan also includes transaction fees of $3,300 and a late penalty of $1000. These additional costs are added to the original loan amount to calculate the APR. Thus, $304,300 will be used to calculate the annual interest amount which will be $18,258 (304,300*6%). Thus, the APR can be derived by dividing the annual payment from the original loan amount. ($18,258/$300,000=6.09%)

What is Note Rate?

Definition of Note Rate

Note Rate is also referred to as ‘nominal rate’, and this is the original rate borne by a loan. This type of loan agreement specifies the rate of interest payable over the loan period. It is the general interest rate quoted by banks when offering loans. Continuing from the above example,

E.g., If the loan of $300,000 is taken out for the interest of 6%, then the annual payment will be $18,000.  This excludes any other costs attached to the borrowing

What is the difference between APR and Note Rate?

Summary – APR vs Note Rate

The difference between APR and Note Rate is dependent on which costs are taken into consideration in its calculation. Due to the inclusion of total cost, use of APR is more beneficial than Note Rate. It also allows effective comparison of rates than the Note Rate. On the other hand, Note Rate is the usual rate used to demonstrate the annual interest on borrowings by many financial institutions.

References

1. com. “Annual Percentage Rate – APR.” Investopedia. N.p., 03 Feb. 2017. Web. 06 Mar. 2017.
2. Kosova, ProCredit Bank. “What are the costs of a loan?” ProCredit Bank Kosova. N.p., n.d. Web. 05 Mar. 2017.
3. Staff, Investopedia. “Transaction Costs.” Investopedia. N.p., 08 Mar. 2016. Web. 06 Mar. 2017.
4. “APR vs. Interest Rate from Bank of America.” Bank of America. N.p., n.d. Web. 06 Mar. 2017.

Image Courtesy

1. APR Calculation – By Petteri Aimonen – Own work, Public Domain, via Wikicommons