APR or Interest Rate?

Understanding the difference between the two and the rules that lenders apply can help prevent you from making a very expensive mistake.

Interest Rate

The main rate you see advertised by the lenders. It simply declares the interest rate that you will be charged on your loan without any other costs such as arrangements fees included. As such, it is not a true representation of the "cost of borrowing".

APR (Annual Percentage Rate)

Introduced by the Government in 1974, it's an attempt to force all lenders to quote the true cost of borrowing, by including all the associated costs of setting up a loan. In the case of mortgages, this means costs such as Arrangement Fees, Valuation Fees and Mortgage Indemnity Insurance are all included. It follows that the APR rate will always be higher than the basic interest rate quoted.

The problem with mortgages and APR is that lenders are allowed some flexibility in how they actually quote their APR. This means that you still can't be sure that the APR you are looking at in an advertisement would be the APR you would pay!

Different Methods of Charging Interest and Why it Matters

Be aware of how your mortgage lender charges interest. Most of the new flexible mortgages on the market apply interest on a daily basis and then adjust it monthly. This is a significant advantage because it means that you only pay interest on the actual amount of loan outstanding. If you are able to pay extra capital off at any time, the interest charges will reflect this change immediately, reducing your monthly repayments accordingly.

Most traditional mortgages, on the other hand, adjust interest rates either monthly or annually.

Interested Adjusted Monthly

This is probably the most common method of applying interest. The Bank or Building Society adjusts the interest rates monthly, if necessary, although in practice only when the Base Rate changes. The effect of a monthly appraisal of interest is that if you make repayments above your monthly repayments (to pay off the loan early, etc) you can end up being charged interest on capital you might have already paid back, for up to one month.

Interest Adjusted Annually

This is the one to wary of. The lender applies a single interest rate to its borrowers, which it adjusts just once a year. The problem with this is that if interest rates rise a couple of times through the year, the following year, the lender effectively slams a "double whammy" on its borrowers. First of all, it increases the interest rate in one jump to the new prevailing level and then it increases it further to make up for the low interest rates the borrower paid in the previous year. The effect of this is that the borrowers can suddenly find their mortgage making a large, unmanageable jump up at the start of the new mortgage year. This method of interest adjustment is usually applied by Building Societies, though by no means all of them. AVOID IT IF YOU CAN.

The Upshot

Whatever type of mortgage you've got, avoid annually adjusted loans.

If you like or intend to make extra payments to reduce your mortgage debt, consider a flexible mortgage, it could save you money.

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