When It’s APR vs. Interest Rates, You Can Be the Winner

“Annual percentage rate (APR) vs. interest rate” is a common way of looking at an important question when it comes to borrowing money: How much does it cost?

The interest rate on a loan is a percentage charged against the principal, which is the amount borrowed. If you borrow $200 and the interest rate is 10%, you will pay $20 in interest charges over the life of the loan.

The APR, or annual percentage rate, gives a fuller picture of the cost of borrowing money by including fees that lenders often charge. What if a person borrows $200 at 10% interest and the lender adds a $20 processing fee? That means that, in effect, the borrower is getting $180 but still paying $20 in interest charges. The APR in this simple example would be 11.1%.

The difference between a 10% interest rate and an 11.1% APR might seem small. But the bigger the loan amount and the longer the term of the loan, the more money that difference represents. That’s why it’s important to understand APR vs. interest rate.

What Are Interest Rates?

In terms of consumer loans, the interest rate is a percentage of the principal that the borrower pays to the lender. Some loans come with a fixed interest rate and others come with a variable interest rate, which means the lender can change the rate over the life of the loan.

Consumer loans typically use simple interest, which means the interest rate applies only to the principal that remains from the loan at a given time. This is slightly different from the interest rate you receive for, say, a savings account or certificate of deposit. Those types of accounts use compound interest, which means the interest rate is applied to the principal plus any amount that accrues through previous interest payments.

A lender bases its interest rates for loans on many factors. One of the primary factors in the U.S. is the interest rate set by the Federal Reserve, which sets a sort of baseline rate for banks to use. A change in this rate by the Fed is usually what causes a change in the variable rate of a consumer loan (like a personal or student loan).

Also, a lender will offer different interest rates on the same type of loan to different consumers. Generally speaking, you may qualify for a lower interest rate on a loan if you have a positive credit rating and a good payment history. That would all be reflected in your credit score. Alternatively, you could be charged a higher interest rate if the lender considers you a high credit risk.

What Are Annual Percentage Rates?

It is important to understand the annual percentage rate when you’re applying for a loan. The APR reflects the total cost of the loan by adding together the interest charges and any applicable fees and expressing that amount as a percentage. (Remember our example from earlier?) If there are no fees with a loan, the APR and the interest rate are the same. Otherwise, the APR will be higher than the interest rate.

Home mortgages tend to have the most fees. Credit cards often have no fees. Personal loans tend to come with an origination fee, but you can find personal loans with no fees, too.

Here are examples of the kinds of fees that can come with a loan:

  • Origination fees
  • Points, including discount points, which is money paid up front to reduce the nominal interest rate
  • Administrative fees, such as underwriting, loan processing, and document prep
  • Title fees for things like closing costs and insurance
  • Attorney fees
  • Mortgage insurance premiums
  • Prepaid interest, which is paid from the time that the borrower closes to the end of the month

APR and Personal Loans

Personal loans often have just an origination fee and are made for a fixed rate and a fixed time period. The determination of the APR is fairly simple when there’s only one fee to consider.

Among the things that factor into the interest rate are the amount of a loan, the down payment (for car loans and home loans), and the length of a loan. Your credit score is also a factor, so it’s a good idea to do what you can to elevate your credit score before applying for a loan. A great credit score could get you a lower APR by lowering both the interest rate and the origination fee.

With any loan, you should consider both the APR and the interest rate. You also should look at all fees and figure out the total cost over the life of the loan.

Can a Personal Loan Save Me Money on Interest?

Depending on your financial situation, a personal loan could help you save money on interest — especially if you consolidate high-interest rate credit card debt. Take inventory of all the debts you owe, and make a list of your outstanding balances, interest rates, and monthly payments before you apply for a personal loan.