It’s important to understand the difference between interest rate and APR when you’re looking for a loan. Sometimes, borrowers are so focused on finding the lowest interest rate that they don’t realize that the APR may better help them compare the total cost of different loans. In fact, a loan with a lower interest rate might cost you more in the long run.
Read on to learn how your interest rate and APR might differ, and how knowing the difference may save you a lot of money in interest.
What is interest rate?
Interest rates tell you what you’ll pay for borrowing the principal (the amount of money borrowed) once the loan is made. It is expressed as a percentage applied to the loan balance, usually each day.
The interest rate applies to the lifetime of the loan, from the day it’s borrowed to the day it’s paid off.
Interest rates can be fixed or variable. With a fixed interest rate on loans, you’ll always know exactly what you’ll owe and can plan each payment more easily. Variable interest rates are tied to a benchmark rate, like the prime rate which is influenced by the Federal Reserve’s federal funds rate. Because of that, interest rates on loans may go up or down when the Fed moves its rate.
What is Annual Percentage Rate (APR)?
An Annual Percentage Rate (APR) shows the total price you pay to borrow money. The APR takes into account not only the interest rate, but also additional costs like lender fees.
APR is calculated from the following:
- Interest rate: The amount of money you owe for borrowing the loan principal.
- Other finance charges: These might include prepaid finance charges or points and other less common fees.
- Any other associated fees: Loan origination fees and closing costs are common charges. Depending on the lender, other fees may also apply. Keep in mind that even when a lender doesn’t charge fees, the APR may still differ from the interest rate based on things such as when the loan is disbursed and when the first payment is due.
If there are no fees, the APR is generally the same as the interest rate. However, if a lender charges an origination fee, for example, then the APR will be higher than the interest rate due to the additional fees.
Why do you need to understand both the APR and the interest rate?
Borrowers often look for the lowest interest rate, but this can be tricky. An interest rate calculates the periodic cost of borrowing the principal (the set amount of money). It’s a good way to understand what you’ll pay each year for your loan.
The APR gives you a longer-term picture of the total lifetime costs of the loan. This is a more comprehensive view of what you’ll need to pay back because it includes the base interest rate plus any additional charges for securing the personal loan. (Principal + interest + any fees or penalties.)
When you’re comparing loans, it’s wise to look at the APR as well as the interest rate. It’s possible that a loan with a lower interest rate will cost you significantly more in the long run due to additional costs built into the APR. In other words, the loan with the lowest interest rate may not be the most cost-effective choice.
How are interest rates and APRs determined for a personal loan interest rate?
There are multiple factors that determine a borrower’s approved interest rate and APR for a personal loan:
- Credit score
- Credit history
- Loan term
In addition to the APR, you’ll need to consider what you can and cannot afford, what value you’ll get out of the loan and what you value in a lender.
How can you use APR and interest rates to help you choose a loan?
As with any financial decision, it’s good to be informed. Remember that the APR is the total cost of borrowing, including up-front fees, so it gives you a more accurate picture of the financial obligation a loan requires. Your loan servicer should be able to answer any questions you have about these rates so that you fully understand the total cost of borrowing.
Additionally, take both rates and fees into account when comparing lenders. What looks like a few percentage points can mean big savings over the life of your loan.
Discover Personal Loans doesn’t charge borrowers loan origination fees, or any other fees provided you make your monthly payments on time. This means that you can calculate the full cost of your loan and choose a loan term that gives you a monthly payment you can budget for.