36 – Interest Rate vs. APR: What’s the Difference?

Wayne  0:03  

Welcome to the Debt Matters podcast where we help Canadians find solutions to their debt with Licensed Insolvency Trustees from across Canada. I’m Wayne Kay and in today’s show, we’re going to be talking about interest rates versus APR. What’s the difference? Don’t worry, you’ll learn about it all in just a couple of moments. 

My Licensed Insolvency Trustee for today, Rob Johnson, is joining me from Allan Marshall and Associates offices in New Brunswick, Nova Scotia, Prince Edward Island and the new office in Alberta. Rob, thanks for being here.

Rob Johnson  0:33  

Thank you. Thank you for inviting me today.

Wayne  0:35  

You got it. Why don’t we start off with a little bit about your history? How long have you been doing the money thing?

Rob Johnson  0:41  

Oh, the money thing? Well, to be honest with you, I’ve been in professional practice since probably 1995. I started out in accounting, became a Chartered Accountant and a CPA, but then moved into insolvency in 2002, and eventually got licensed as a Licensed Insolvency Trustee. Initially, my career started at Ernst and Young as a vice president, and then I eventually moved over to Allan Marshall and Associates to practice more on the consumer side.

Wayne  1:08  

Terrific! It’s always great helping people out because with this show, we’re talking about people who are in financial difficulty. They don’t know where to turn, and there’s so much bad advice out there. That’s why we’re here talking with Licensed Insolvency Trustees who are regulated by the federal government, and they’re here for your best interests. 

So the big topic today, and I like this because you can put on the accounting hats, etc, and really dive deep into explaining interest rates versus APR. What is APR?

Rob Johnson  1:41  

Well, APR defined actually is just the annual percentage rate, and essentially, it’s just a calculation that includes both the loans interest rate and the loans finance charges. This is expressed as an annual cost over the life of the loan. In other words, it’s essentially the total cost of credit –  APR accounts for both the interest fees and over a period of time. 

Just to give you an example… So if a loan’s posted interest rate is 2.91%, and that loan comes with financing costs and stuff like that, and say the average financing cost is .08% for fees and expenses of the loan annually, or $80 for every $100,000 borrowed – then that’s the APR on the loan. So the average percentage rate would be 2.99 and not the 2.91% posted by the bank. Comparing this to an actual interest rate, the interest rate is essentially just the interest or the interest cost to borrow. That doesn’t include any of the financing costs, or anything else that might be hidden, that you might not be aware of.

But when it comes to interest, everybody knows what interest is. For example, when you borrow money to buy a home or car, you pay interest. And that’s usually the posted rate. Just like when you lend money, you earn interest. So for instance, if you have a savings account or certificate of deposit, you’re lending money to a bank – they’re paying you a small return, so you’ll have an incentive to deposit more money there. 

So that’s kind of a quick Coles Notes version of what an APR is versus an interest rate. Interest rate is just posted number, the annual percentage rate actually includes all the lending costs that tend to be hidden in the background,

Wayne  3:23  

Is this something that us consumers need to be paying attention to?

Rob Johnson  3:28  

Yes, this is very important, because just looking at the posted interest rate. You’re not getting a true picture of what the true financing costs are – whether there’s brokerage fees, loan fees, or other hidden costs with regards to the financing agreements with the lenders. So yes, it kind of takes in all the costs with regards to the loan and puts them into an average interest rate, so you know what your true cost is of borrowing.

Wayne  3:53  

Do you find a lot of people don’t pay attention to the true cost? And I guess when I think about true cost, I think about if you were to use your credit card at 21%. And you don’t pay off a certain loan on the credit card for five months, you need to add that on. To me, that’s part of the cost. Do people not pay attention to those kinds of things enough?

Rob Johnson  4:14  

No, most people usually follow the stated interest rate. They tend to forget about the extra cost, especially when it comes to, say for home mortgage. That’s a common area that uses both APR and interest rates. Since the APR includes both the interest rate and fees associated with the home loan, the APR can help you understand what the total cost of the mortgage is if you keep it for the entire term. 

The APR is going to be undoubtedly higher than the interest rate, but sometimes there are exceptions. One is a no claw, no closing costs refinance. In this case the interest rate and the APR tend to be the same because there is no additional cost, so they match. Another would be an adjustable rate mortgage, or the acronym would be ARM. The APR for an ARM will sometimes be lower than the actual interest rate. And this can usually happen in a declining interest rate environment where lenders can assume in their advertising that your interest rate will be lower when it resets upon refinancing, compared to when you originally took out the loan. 

However, the APR on an adjustable rate mortgage is only an estimate because nobody can really predict what will happen in the interest rates over the long term of the loan. Say for 25 years, it was a little hard to predict how rates are going to go. So accordingly, the APR on the ARM will only be known after the loan is actually paid off, you can actually tabulate what the true interest costs were. But again, a lot of people forget to factor in all the hidden costs with regards to taking on larger loans.

Wayne  5:52  

So are there certain places where this is more common? You mentioned for mortgages, what other areas would you be worried about?

Rob Johnson  6:00  

Another one would be – we typically see these payday loan companies have a stated interest rate, but they tend to have all these additional costs, and fees added on after the fact. So if you were to actually stand back and look at all the costs and put those on to the interest rate that they’ve posted, you’ll find that your true cost of borrowing is far, far higher.

Wayne  6:25  

So this is something – well anybody who’s listened to the show for a while knows to be very cautious when it comes to those payday companies that are out there. We don’t name them in specifics, but you can definitely fall into a trap. 

Rob Johnson  6:39  

A lot of times that stuff is misleading, too, right? And it doesn’t properly inform the consumer when they’re getting into these agreements.  And you’re correct with your cautionary advice.

Wayne  6:51  

Well you see it all the time, right? You see a lot of people that get into financial trouble. And sometimes, there’s not much you can do. If somebody gets sick or anything happens, all of a sudden, your debt starts growing. 

And then you’re like, you know what?  I know, I’ve got a pay day coming up, I just need something quick. I’m already maxed on everything. What am I going to do? Then they go hit up one of those payday places. Unfortunately, they don’t get it paid off right away and then that’s where trouble starts. So you can see how it actually happens.

Rob Johnson  7:20  

Correct, exactly. And then what they’re doing is they’re going in and refinance that payday loan, every payday. That allows it to essentially grow as far as the principal for it each time because of the interest and the fees being included on each individual loan. 

Wayne  7:38  

How important is it to be focusing on interest rates? So a two part question: How important is it? And do you have much leverage to actually change interest rates?

Rob Johnson  7:48  

Well, interest rates, of course –  it’s a great number to compare lenders from one lender to the next. However, interest rates, again, don’t include the true cost of borrowing. However, as a preliminary detail, it helps you look at one lender versus another.

But at the end of the day, the only thing that pretty much has an effect on your interest rate being offered by lenders, is based on your credit rating. The higher your credit rating, of course, the lower risk you are. They’re more likely to lower the interest costs versus a higher risk person with a lower credit rating. Of course, they’re going to be subject to higher interest rates, just because it’s a reflection of the risk involved in the loan. But again, these don’t include all the costs associated with lending as the APR or the annual percentage return.

Wayne  8:38  

So I guess you would come across as a very educated consumer, when you start asking about the APR.

Rob Johnson  8:45  

Correct. Yes, because those are the costs that they don’t want you to know, at the beginning until just like with a car, right? You sit down to buy a brand new vehicle. You’re paying point 9%, then all of a sudden, they’re adding on your environmental fees, your air conditioning fees, your shipping, your delivery, and everything else. So that changes everything rapidly. Because those are true costs of the loan.

Wayne  9:09  

Absolutely. I’ve seen that where you go onto a website, and you look at buying a car, and you start looking at the different numbers. But then you have to check the box at the taxes, add in the shipping, add in this and that and then delivery, the PDI and all of a sudden my $320 Car Loan is now $400. So exactly, that’s what you’re talking about. 

Okay, good to know, these are good things that we can use. So what do you say to consumers? How do they go about understanding more about this – or is that pretty much it? You just have to look at: What are the hidden costs?

Rob Johnson  9:48  

Well, essentially, you want to know what your interest rate is and you want to talk to each lender. Individually and to essentially find out what is the additional cost or whether there are any costs, what they are and how they factor in over the term of the loan.

Again, this is very important when comparing lending agreements between various lenders to help determine which loan is cheaper, by using the APR instead of the posted interest rate, which doesn’t provide all the hidden costs of the lending agreements. So by comparing interest rates alone, that’s not enough to protect you, or to ensure that you’re getting a better deal.

Wayne  10:24  

If you have a debt and you’re carrying, I don’t know, let’s say some credit card debts or maybe student loan debts, and you do have the option of a line of credit. What do you suggest to people who are carrying the higher interest rates? Do they move at all into a line of credit, if possible, or what’s your recommendation for that?

Rob Johnson  10:51  

Well, if you’re dealing with a lot of credit card debt, that’s probably around 19 to 24.9% per annum on each credit card. That doesn’t include any type of other fees that might be subject to the credit card, versus the line of credit. Typically, you see those depending if it’s secured, down to 2 or 3%, upwards of 6 or 7% for the unsecured ones. 

So just looking at interest rates alone, a lot of times it makes sense to move the debt from the higher interest facility to the lower one so you can save on interest costs, and actually pay down the principal a little faster. Get back on track, and to essentially resolve any debt issues, while saving interest. 

However, the smart part to do with regards to moving debt from cards to line of credit, would be to significantly reduce the limits on those cards so you don’t rack them up again, and get back into the same scenario while you’re trying to pay down the line of credit. So the smart thing there is either to destroy or cancel a card or have the limit lower down to $1,000 or $2,000. Basically, what you might need in an emergency situation while you take care of the debt that has incurred over time.

Wayne  12:01  

Okay, that’s good advice, because there’s people listening, and they do have very high credit card debt. They don’t know what their options could be so this is really good advice for them. Maybe look at different options. Student loans, are those fairly low?

Rob Johnson  12:15  

Student loans – well it’s been a while since I’ve looked at the student loan percentages, but I remember back in the day, when I was doing my student loans and paying them off. I think I was paying 3% plus prime. So student loans typically are fairly cheap. I don’t know, 5% or 6% now I’m not quite sure. But you have to remember the interest paid on a student loan is income tax deductible. So actually, you’re getting some of that interest money back over time.

Wayne  12:42  

Okay, good to know. Good advice there, by the way. So what else do we need to know? Anything we need to know about interest rates versus APR?

Rob Johnson  12:52  

Well, another thing when you’re seeing your identical interest rate and APR alongside one another that’s usually a signal that the lender is not charging any fees to qualify for their rate or their interest rate. So you know there are no upfront costs or any costs associated with the financing. You can find an APR and interest rate alongside one another. The interest rate and the APR, which essentially means there’s no hidden fees.

Wayne  13:18  

Perfect. Well, I think we’ve kind of covered everything that we need to know regarding APRs and interest rates. Any final words of advice for us?

Rob Johnson  13:27  

Again, always be a cautious consumer out there and always understand whatever the loan agreement is that you’re getting into. Always look at the fine details and know all the costs, whether you know whether they’re upfront or after the fact and never rush into anything until you fully understand it.

Wayne  13:43  

Love it. Rob, thank you very much for coming on the show and giving us these details.

Rob Johnson  13:48  

Thank you.

Wayne  13:49  

My guest today, Rob Johnson Licensed Insolvency Trustee and if you want to schedule a free consultation with Allan Marshall and Associates – yes, the first one is free. You can go to wecanhelp.ca. 

That is it for today’s Debt Matters podcast. Just make sure you subscribe wherever you get your favorite podcast from and of course, for more information, you can always check out debtmatters.ca Thanks very much for listening.