Purchasing a home is a big commitment, and for the vast majority of us, it requires taking out a substantial loan. There are several important terms you should know, but two of the biggest ones are ‘interest rate’ and ‘APR’.

What is an interest rate?

An interest rate is a fee you pay to borrow money from a financial institution or another lender. Essentially, it is the cost of borrowing money. In addition to paying back the money you borrowed, a small amount of each payment goes to the bank. Almost all loans have some kind of interest attached.

What is the APR?

The APR, or annual percentage rate, includes any fees and points that are tacked on to your loan in addition to the interest rate. Fees can include an “origination fee”, which typically ranges from 1 to 8%, to cover the cost of processing the loan.

Points are a percentage of the loan that can be paid overtime or upfront. If you pay upfront, you can usually secure a lower interest rate.

How much can I expect to pay in interest and APR?

In some loans, the interest rate and APR are identical, with no cost differences between the two. This is not always the case, so it’s important to read the fine print of your agreement.

Here’s an example to highlight the importance of the APR:

Let’s say you take out a $10,000 personal loan that you plan to pay back within five years. If you get a 5% interest rate and no further fees, your interest rate and APR will both be the same at 5%. You will pay back a total of $11,322.74 with interest over the life of the loan.

Now, let’s say you are offered the same $10,000 loan, with a lower 4.5% interest rate and a $200 financing fee. Are you getting a better deal? Your loan is lower, but your APR would be 5.31% if the payment was amortized over the life of the loan. The total cost would now be $11,409.53 over the next five years. Even if you pay the fee upfront, you will still pay $11,385.81 for the loan.

As you can see, understanding the APR of your loan is important. When the advertised interest rate of one option appears low, you should always compare the APRs to make sure you are getting the best overall terms. All lenders are legally required to calculate the APR the same way – make sure to ask your lender about the APR, points, and financing fees before you sign.

Common Loan Pitfalls to Avoid

Often, when something seems too good to be true…that’s because it is. Ideally, you want to look for a lender that does not require you to pay a hefty fee on top of your loan.

More importantly, you want to consider the interest rate and the APR to get the whole picture. Sometimes, contrary to the example above, paying the fees is actually worth the low-interest rate.

At the end of the day, as with anything loan-related, you want to shop around for the best interest rates and APR possible. Between online lenders and brick-and-mortar banks, you now have more options than ever before – make sure you understand the terms before signing and you should be good to go.