Whether you're shopping for a home loan or picking out a new credit card, you should know that the advertised APR represents more than the interest rate you're charged. Where your interest rate is represented as a percentage and describes how much interest you'll pay over time, the APR also includes fees and other charges.
What does this mean when it comes to comparing interest rate vs. APR? Generally speaking, this means the APR is typically higher than the interest rate you'll have to pay (but not always). Read on to learn about these two terms and everything that sets them apart.
- While the terms "interest rate" and "APR" are often used interchangeably, these are not exactly the same.
- You can compare loans based on their interest rate or APR, but make sure you're comparing them with the same one across all lenders.
- Ultimately, your interest rate and APR will determine how much money you'll pay when you borrow.
Interest Rate vs APR: What’s the Difference?
Any time you borrow money, you will want to compare lenders based on the interest rates they charge. Interest rates are expressed as a percentage as we already mentioned, which you will quickly discover when you compare financial products. As an example, the Board of Governors of the Federal Reserve System says that, as of February 2023, the average interest rate on a 24-month personal loan came in at 11.48%
Meanwhile, an APR takes the interest rate for a loan and adds in any fees that are charged. With a credit card, this means the APR includes the interest rate and other fees that can be charged like an annual fee.
Example of Interest Rate vs. APR
The best interest rate vs. APR example usually comes from mortgages since this type of loan has plenty of added fees that need to be paid. For example, mortgages require borrowers to pay interest on their loan, but borrowers may also pay points on their mortgage, closing costs, mortgage insurance premiums and more.
With some mortgage lenders, for example, you can qualify for a 15-year, fixed rate home loan with an interest rate of 5.50% and an APR of 5.658%.
What Is Interest Rate?
An interest rate is a numerical figure that describes how much interest you'll pay when you borrow money, expressed as a percentage.
- Interest rates vary. Interest rates can be higher or lower for various financial products. For example, mortgages and personal loans tend to come with much lower interest rates than credit cards.
- Interest rates can be fixed or variable. Some financial products come with fixed interest rates that stay the same for the duration of the loan term, whereas other financial products have variable rates that fluctuate based on market conditions.
- The interest rate you're assigned can depend on your creditworthiness, your income, and other factors. Generally speaking, you'll qualify for the lowest interest rates when you have a good credit score or an excellent credit score.
How Are Interest Rates Calculated?
Lenders calculate interest rates using a few different methods — simple interest and amortizing interest.
With simple interest, you make the same monthly payment each month but the interest charged is based on the original loan balance and the remaining loan balance as your debt is paid down. This means the amount of interest you pay each month goes down as your loan balance decreases.
Simple interest example: To determine simple interest on a loan, you'll use the following calculation:
Loan amount x interest rate x loan term = interest
This means that, with a $10,000 personal loan with a 5% rate and five-year repayment term, the formula would be as follows:
$10,000 x .05 x 5 = $2,500
With an amortizing interest loan, however, more interest is charged toward the beginning of the loan until a good part of the balance has been paid off. At that point, the tables turn and the amount of interest being paid off begins to drop. Toward the end of a loan with amortizing interest, hardly any interest is charged.
Amortizing interest example: The formula for an amortizing interest loan is considerably more complicated, and you'll probably need a loan calculator to figure it out.
Either way, imagine you take out a $10,000 loan at 5% with a ten-year repayment term. In this case, the schedule below shows how interest is higher toward the beginning then lower toward the end of the loan term.
|Loan Year||Total Principal Paid||Total Interest Paid||Remaining Balance|
What Is APR?
APR is a term used to describe a financial product's interest rate plus fees that are charged. In other words, APR is meant to portray the total costs of borrowing money.
How Is APR Calculated?
Because many credit cards and lines of credit don't charge an annual fee or other required fees, it's common for credit cards to have the same interest rate and APR. Other financial products, like personal loans and mortgages, typically have an APR that is higher than the interest rate alone.
To figure out a loan's APR, you'll need to know:
- The loan balance
- Interest rate being charged
- Fees that are charged
- Days in the loan term
Fortunately, you don't have to determine an APR on your own. The Truth in Lending Act (TILA) requires lenders to disclose an APR for each of their financial products.
The Federal Truth in Lending Act requires lenders to disclose all fees and charges that can be included in their loan products. This includes both interest rates and APRs that are inclusive of fees.
To find an example of a loan's interest rate vs. APR, do a quick search for mortgage rates in your area. The screenshot below was taken from the Chase Mortgage website. As you can see, it shows the interest rate for various types of home loans, as well as the APR. The APR is higher since it's inclusive of both the interest rate and mortgage fees that are charged.
In this example, you can easily see that the interest rate on a 30-year, fixed rate mortgage is 5.750% as of publishing, but that the APR for the same loan is 5.840%.
Why Do Interest Rates and APR matter?
Whether you decide to compare loan offers based on the advertised interest rate or APR, you should know that both are important to consider. The interest rate you're charged will directly impact how much interest you pay when you borrow, and the APR does the same except it also takes loan fees into account.
Monthly Payment Impact
The interest rate and APR you pay for loans can easily save you (or cost you) tens of thousands of dollars over the course of many years. Let's say you take out a $300,000 fixed-rate home loan with an APR of 5%. In this case, your monthly payment (including principal and interest) comes in at $1,610.46 during that timeline.
Now imagine you get the same mortgage, but with a 7% APR. In that case, your monthly payment goes up to $1,995.91, which means you're paying $385.45 more in monthly interest at the beginning of the loan.
Impact On Total Borrowing Costs
Considering the example above, you can also see how your total borrowing costs can increase dramatically based on your interest rate and APR.
After all, making a $1,610.46 monthly mortgage payment for 30 years (360 months) means you pay a total of $579,765.60 and $279,765.60 in interest charges over that time.
With the same loan at 7% and a monthly payment of $1,995.91, however, you would pay $718,527.60 in total and $418,527.60 in interest charges.
How to Compare Loans Using Interest Rate and APR
If you're in the market for a loan and wondering where to borrow money, you should know that online lenders make the process easy. The following steps can help you compare lenders based on their interest rates, APRs and other important details.
- Compare loans based on APR since this considers loan fees. While interest rates are important, comparing loans based on their APR is better since this factor considers annual fees, origination fees, and other loan costs.
- Look at three or more lenders and the APRs they charge. Make sure you look at loan offers from a few different lenders and don't go with the first one you find.
- See if you can "check your rate" without a hard inquiry on your credit reports. Many online lenders let you gauge your approval odds and see the interest rate you'll pay without filling out a full loan application.
- Use a loan calculator to see what your payment might be. Loan calculators let you plug in some numbers to see information like your anticipated monthly payment and total interest charges.
- Choose the loan with the lowest total loan costs you can find. Once you compare several loan offers and use a loan calculator to see how your total loan charges would look, you can settle on a loan the offers terms you can live with.
How to Get the Best Interest Rates and APRs
To qualify for the best interest rates on the market today, you'll want to do the following:
- Improve your credit score. Your credit score is used to determine the kinds of rates you can qualify for, so take steps to improve it like paying your bills on time and reducing the amount of debt you owe.
- Have a verifiable income. Being able to show stable income can help you qualify for loans with the best rates and terms.
- Compare lenders online. Different lenders can charge different rates based on the information in your credit application, so make sure to shop around.
- Watch out for fees. While interest rates are important, make sure to look at loan fees and how they impact the APR for various loan products including business loan products, working capital loans, and more.
Understanding the interest rate vs. APR difference is crucial as you compare loan offers, mostly because these terms will impact how much you pay when you borrow money. Also know that you can compare lenders using either metric — interest rate or APR. Just make sure you're making an apples-to-apples comparison among lenders (comparing APRs or interest rates without mixing them) when you do.
Ideally, you'll find a loan with the lowest interest rate or APR you can find. Doing so can help you secure a lower monthly payment and lower interest costs in the long run.