A loan always costs more than the amount borrowed due to the risks a lender takes, inflation, and other factors. All offers you’ll see when shopping for a loan include interest rate and APR to reflect the costs a borrower must cover.
Learning the differences between APR vs. interest rate before borrowing will enable you to make better financial decisions and ultimately save you a lot of money.
The interest rate only reflects the percentage of the total loan amount, also called the principal, a lender charges to allow a borrower to use its assets, most commonly cash. APR includes the interest rate and all other costs associated with a loan.
Here’s what you should know about APR and interest rates before borrowing money.
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Understanding Loan Interest Rates
Lenders take a certain amount of risk when they give a loan to a borrower; hence they charge a fee for allowing a borrower to use their assets, such as cash or property.
This fee is called an interest rate. It indicates the percentage of the principal the borrower has to pay back to a lender. Long-term loans usually have higher interest rates than short-term loans because a borrower has more time to default on a loan.
Risk coverage isn’t the only reason lenders charge interest rates on loans. Inflation and opportunity costs are also among the reasons lenders use interest rates to protect their capital.
Inflation devalues money over time, so as the prices increase, the value of money decreases. Consequently, interest rates protect lenders against inflation and ensure they receive the equivalent amount they’ve borrowed.
Interest rates don’t only depend on current market conditions. The borrower’s credit score, l, and repayment term also play an essential role in determining a loan’s interest rate.
The Essentials of Annual Percentage Rates
Although it’s expressed as an interest rate, the annual percentage rate doesn’t only specify the fraction of principal a lender charges for a loan. APR shows all loan costs a borrower has to pay each year, including interest rates.
As a result, APR is always higher than the loan’s interest rate. The fees included in an APR depend on the lender and loan type. Here are some of the most common fees APR can consist of:
- Origination fee
- Underwriting fee
- Discount points
- Costs of closing an account
- Loan application costs
- Administrative fees
Remember that the APR does not include down payments, so a sizable down payment on a loan can help you decrease the APR.
The annual percentage rate gives borrowers a more realistic view of the loan’s costs than the interest rate because it includes all fees rather than just the percentage of the principal.
Types of APR And Interest Rates
Personal loans, mortgages, and other loan types have different interest rates and APRs. For instance, the average interest rate for a mortgage is 6.98%, while personal loans usually come with interest rates above 10%.
APR for a personal loan often combines the origination fee with the interest rate, which is why it’s commonly 1% to 5% higher than the loan’s interest rate.
On the other hand, the average APR for a fixed-rate mortgage is 7.10%, but some lenders offer mortgages with APR over 15%.
Lenders use the following types of interest rates:
- Simple interest rate: The borrower pays a fixed or variable interest rate to the lender in addition to the entire principal amount.
- Compound interest rate: The lender charges the interest on the principal and the interest on interest accrued during the compounding period.
APR and interest rates can be fixed or variable. A fixed APR or interest rate remains unchanged during the repayment period unless the borrower falls behind on payments.
Variable APR depends on the prime rate that changes every six weeks, so the loan’s APR fluctuates depending on the current prime rate.
The Differences Between Interest Rates And APR
The Truth in Lending Act of 1968 compels lenders to disclose interest rates and APR for each loan offer. Hence, you can quickly check the loan’s APR and interest rate before applying and committing to its terms.
Both values depend on the market conditions, loan type, and credit score. The difference is that the interest rate never shows the loan’s total cost.
A loan’s APR and interest rate can be the same if the lender doesn’t charge additional fees for that loan. However, APR is usually higher than the loan’s interest rate, and it reflects the actual cost of borrowing money more accurately than an interest rate.
Calculating APR And Interest Rate
Lenders use a broad spectrum of factors when determining a loan’s interest rate. The lending climate or the prime rate are among the factors you cannot control, so your interest rate will often depend on when you take out a loan.
Removing negative items from your credit report and having a stellar payment history will improve your credit score and lower the loan’s interest rates. The same applies to APR.
The average APR for personal loan borrowers with credit scores between 720 and 850 is 11.3%. APR for borrowers with bad credit scores under 630 is usually around 25%.
The formula for calculating interest rate amounts is simple. For instance, if you want to take a $20,000 loan with a 10% interest rate, at the end of the loan term, you repay $22,000 to the lender.
You can calculate the monthly loan payment amount by dividing the total interest rate amount by the number of payment periods. So, if you take a one-year loan, your monthly payment will be $166.66, provided the loan has no additional fees.
Calculating APR is slightly more complicated as the calculation depends on a loan type and the fees it contains. Fortunately, you won’t have to do the math because the lender must provide you with the exact APR amount before you accept a loan.
Choosing Loan Offers Based on APR and Interest Rates
Neglecting to check a loan’s interest rate, and APR can be a costly mistake because some lenders offer loans with lower interest rates but high APR and vice versa.
For example, a loan can have a 3% interest rate, but its APR could be over 20% which means you’ll ultimately pay more than if you take a loan with an 11% interest rate and 12.5% APR.
It’s important to remember that the interest rate and APR will depend on the amount you want to borrow, the loan’s repayment period, your credit score, and the current prime rate.
A lender is more likely to offer you a loan with a low interest rate if you have a high credit score, but loan fees may be relatively high even if your credit score is over 700.
Some lenders started introducing changes to their fee structures to make mortgage loans more accessible to people with low credit scores.
Regardless of which type of loan you want, the interest rate and APR are the primary parameters you must pay attention to because they reveal how much a loan will cost you.
Comparing APR on different offers will make choosing the most affordable loan easier, while the loan’s interest rate will help you calculate your monthly payment.
Frequently Asked Questions
Here are a few FAQs that may often crop up in your mind before borrowing.
Short-term loans have lower interest rates than long-term loans because they’re less risky. However, long-term loans typically have lower monthly payments than short-term loans because borrowers have more time to repay them.
Monthly payments are based on the loan’s interest rate, as they don’t normally include fees and other charges. Lenders usually deduct expenses from the principal before releasing the funds or charge them to a borrower’s account annually.
A loan’s APR will be zero if the lender doesn’t charge fees or penalties. The interest rate and APR percentage will be the same in this case.
Fixed-rate APR remains the same throughout the repayment term, but a variable APR can increase or decrease depending on inflation, prime rate, and other external factors.
APR vs. Interest Rate Which is More Important for Your Loan Search?
Finding a loan with favorable terms is next to impossible if you ignore interest rates and APR because both values indicate the cost of the money you’ll borrow.
You must consider each parameter when selecting a loan to avoid paying a steep price for borrowing money.
Don’t forget that a lender must disclose these values before you accept a loan, so don’t hesitate to use that information to find a loan that fits your needs and budget.
Author:
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.
