- The APR includes fees plus interest charges, so it reflects the total cost of borrowing.
- If there are no fees, the APR and interest rate are the same.
- It’s good to know whether to use APR or interest rates to compare loans, but it’s also smart to calculate the total cost of borrowing.
When you’re shopping for a loan, it makes sense to look for the best rates. And you may have noticed that besides the interest rate there’s an APR (the annual percentage rate). To many folks looking to borrow money, those terms sound interchangeable. Well, sometimes they are—but often they aren’t. When it comes to APR vs. interest rates, knowing the difference could help you save money on a loan.
As you read this article, you’ll begin to understand both terms and you should see why the APR can sometimes give a better picture of the total cost of your loan.
What is an interest rate?
Simply put, an interest rate is the cost of borrowing money. It’s a percentage added to the amount of the loan you pay, often over a specific time period.
Interest rates may be fixed. Throughout the entire life of the loan, you’ll pay the same interest rate. That’s common for personal loans.
Some loans have a variable interest rate. For example, for a home loan, there’s a specific type of mortgage loan called an adjustable-rate mortgage or ARM. An ARM’s interest rate may change from time to time. Credit cards are the most common form of variable-interest-rate lending. Their rates are usually tied to a national or international bank rate. If that rate changes, your credit card might adjust accordingly.
Let’s consider an example of how interest rates work when you’re borrowing money. Suppose you take a $30,000 personal loan to buy a new car. The interest rate on this fixed loan is 6%, and you decide to finance it over 5 years (60 months). That means that, every year, you’ll pay 6% to the lender on whatever principal amount remains on your loan. So, for this loan estimate, the monthly payment is just about $580.
This chart shows how much interest you’ll pay each year.
|Year||Start Balance||Interest Paid||Principle Paid||Ending Balance|
At the loan’s start, the balance (what you owe) will be at its highest. So, your annual cost for interest will be at its highest. Over the months, as the principal loan amount is paid down, you’ll owe less and less interest. With each month, a higher percentage of your payments will go toward your principal balance. This process is known as amortization; it also applies to personal loans, home mortgages, and student loans.
What is the APR?
The APR, or annual percentage rate, includes not only the interest rate, but also any other costs. Several things can raise the total cost of a loan. The APR is usually greater than the advertised interest rate because there are extra charges involved in securing many loans.
If a mortgage lender provides the funds for your home purchase, for example, there are additional fees. You might have to pay certain costs or loan fees like:
- Origination fees. Basically, these are the lender’s charges for issuing the loan.
- Broker fees. These are charges by the mortgage broker who works on your behalf to secure the loan best suited for you.
- Mortgage insurance. This is an insurance policy to protect the lender in case you default on your loan. It’s also known as PMI or private mortgage insurance.
- Discount points. These are fees paid to the lender to reduce the mortgage interest rate. This is often called “buying down the rate.”
- Closing costs. This is a catch-all term for the little things that get added to mortgages and are paid upfront. APR includes some of these closing costs.
Different types of loans include different types of fees. The APR includes all the fees from the lender. You could be shopping for a loan and find one that has an interest rate of 6.7%. After the extra charges are included, the APR might be closer to 7.3%-7.9%. The Federal Truth in Lending Act (TILA) requires disclosure of the APR on every consumer loan agreement. All lenders must adhere to TILA. So, when you see the APR on a loan estimate, you’ll know what your bottom line really is.
APR vs. Interest Rate: Which Should I Look At?
Both the interest rate and the APR are important, but the annual percentage rate is more complete. It can reflect the full cost of borrowing. The APR will reflect the various loan options for the loan amount, additional costs, and other factors. Remember this: a great interest rate can be completely offset by expensive fees and charges. The closer to your interest rate your APR is, the less you’ll spend on fees and on your loan overall.
Let’s say you’re looking for a 12-month personal loan for $5,000, and you want to do an APR calculation. Lender A offers you an interest rate of 6% with no additional fees. The APR for that also would be 6%.
Lender B offers you an interest rate of 4%, but there’s a 3% origination fee. So, what is Lender B’s APR?
- You first add the interest you’ll pay ($107) and the fee ($150), to get $257.
- Divide that by the loan amount ($5,000) to get 0.0514.
- Divide that by the number of days in the loan’s term (365) to get 0.00014.
- Multiply that number by 365 to get the annual rate: 5.14%.
Now you can see that Lender B (with a 5.14% APR) is offering a better deal, even with the origination fee, than Lender A’s fee-free 6% APR.
When there are no fees involved for either lender, then the APR and interest rate would be the same. This scenario is often the case with credit cards. Most credit cards don’t add fees to their interest rates, so the APRs they advertise are straightforward. But it makes sense to check for annual fees or balance transfer fees, so you won’t have any surprises.
To get the best loan possible, it helps to learn all you can about both the interest rate and APR.