When a bank lends money, it charges an interest rate for this service. And this money also generates associated costs. Both circumstances are reflected in the nominal interest rate and the APR indicators, which are also official and compulsory for the Bank of Spain. The difference between the two and how to calculate them is often not well known.
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What is the nominal interest rate?
The nominal interest rate represents the interest applied by a financial institution or lender for the service of lending money: It indicates the percentage the bank is going to keep for the transfer of funds.
Each bank is free to apply the nominal interest rate that it wants to charge its clients for each type of loan, and it is agreed upon with the applicant for the loan, mortgage, or deposit contract. Therefore, it reflects the payment of interest for the change in the value of money over a period of time.
Thus, the nominal interest rate serves to know what percentage will be regarding the capital loaned, without considering the other expenses associated with the credit operation: It only reflects the cost of the financial product.
How is the nominal interest rate calculated?
The nominal interest rate consists only of a fixed percentage as payment for the borrowed funds, and can be calculated on an annual, quarterly, monthly or weekly basis.
However, it is more common for financial institutions to calculate the monthly nominal interest rate to reflect it in the loan conditions. Thus, an annual nominal interest rate of 7.5% is the same as a monthly nominal interest rate of 0.625% (the result of dividing the annual nominal interest rate value by the 12 months of the year).
With your business management software, you will be able to easily access the repayment information of a loan.
The nominal interest rate in mortgages
Mortgage loans are financial products offered by banks to finance real estate. Financial institutions offer mortgage loans with fixed conditions (with an invariable nominal interest rate) or variable conditions (with a nominal interest rate made up of the addition of the Euribor and a differential).
What is the APR?
The annual percentage rate of charge is the rate that reflects the total costs of the lending of funds, that is to say: The interests set by the financial institution, the commissions, the management costs, or the terms of the operation.
The information provided by the APR allows to obtain a global vision of all the factors that take part in the operation that has been contracted and serves as a comparative indicator between the different banks.
How is the APR calculated?
The APR is calculated with a more complex formula than the nominal interest rate’s: while the latter’s formula only takes the indicator into account, the following elements are involved in the APR formula:
- The value of the nominal interest rate
- Bank charges (for amortization, cancellation, opening…)
- The costs of the operation
- The frequency of payments (monthly, quarterly, six-monthly, annual…)
The website of the Bank of Spain contains an online calculator to simulate the value of the APR, entering all the relevant data of the loan or credit.
The APR on mortgages and loans
However, the Annual Percentage Rate of loans and mortgages does not include the calculation of some costs such as notary, insurance or other products related to the operation.
Nevertheless, banks are obliged by the banking legislation itself to inform clients and visibly show the APR applied in their advertising or promotional elements, as well as in contracts.
What is the difference between the nominal interest rate and the APR?
Financial institutions require to include both types in the conditions of all credit operations, but the differences between the nominal interest rate and the APR are also considerable.
Information bias
Although both indicators are merely informative for the consumer, the nominal interest rate hardly provides relevant information on the nature of the loan or, in other words, how much capital the consumer will have to allocate to meet the costs of the contracted product. Banks usually offer low nominal interest rates to attract the attention of clients.
On the other hand, as the APR provides all the relevant information on the operation, it constitutes a much more valuable element to determine the conditions of the contracted product, how much it contributes an investment or how much does a credit actually cost.
Periodicity and performance
The other big difference between the nominal interest rate and the APR on a deposit is that the former does not have to be annual. In addition, it is quite common to find that personal loans have a greater difference between the APR and the nominal interest rate than mortgage loans. In contrast, deposits or savings accounts usually have a lower APR.
As a consumer, knowing the differences between the nominal interest rate and the APR is essential to choose the best conditions for a bank loan. Try STEL Order to easily keep track of all the information on your company’s balance sheet.
