If you are shopping for a mortgage or personal loan, you may have seen the terms “interest rates” and “APR,” or Annual Percentage Rate.
Many people think that APR is the same as interest rate, and the terms often seem to be used interchangeably. While these terms are related, they are not exactly the same. Knowing the difference will help you make a wise decision when considering whether a mortgage or other loan fits into your budget.
This article explains the difference between APR and interest rate. With this information, you will be able to compare lenders and choose affordable loans that will help you reach your financial goals.
Table of contents
What is interest rate?
Simply put, interest rate is the percentage you pay to borrow the principal amount of your loan on an annual basis. The interest rate applies to the life of the loan, from the day it’s borrowed to the day it’s paid off.
Interest rates come in two varieties: fixed or variable. As the name suggests, a fixed interest rate stays the same throughout the life of your loan. With a fixed-rate loan, you always know exactly how much you owe every month and can better plan for each payment.
Variable interest rates are tied to a benchmark rate, like the prime rate. The prime rate can change periodically, depending on decisions by the Federal Reserve. Because of that, interest rates on loans may go up or down when the Fed moves to change its rate. A variable-rate loan creates some uncertainty about how much you will owe on your loan in the future.
What is APR?
As discussed above, an interest rate is what lenders charge for a loan. APR, which stands for annual percentage rate, is the total price of the loan expressed as a percentage. In addition to the interest rate, the APR includes other borrowing costs like lender fees.
APR and interest rate should be the same for loans that don’t charge fees. But when a loan also has origination fees and closing costs, the APR will be higher.
The Truth in Lending Act (TILA) requires lenders to explain both the interest rate and APR you will pay for your mortgage or loan. Look for this information on the Loan Estimate and in the Closing Disclosure.
Why do you need to understand both APR and interest rate?
Borrowers tend to seek the lowest interest rate when they are shopping for a mortgage or loan. But that may not give you a full picture of the amount of money you will owe.
The stated interest rate calculates only the cost of borrowing the principal. APR is actually a better reflection of the total lifetime cost of the loan, because it includes the base interest rate plus other expenses and fees.
A loan with a lower interest rate may not always be the cheapest option if you must also pay fees. These fees add up, so you will owe more over the life of your loan.
For example, let’s say you wanted to take out a $15,000 loan to be repaid over 72 months. If the loan has a 7.99% interest rate and does not charge any origination fees, the APR would also be 7.99%. In this case, the total cost of the loan would be $18,931.
If the loan instead has a 6.99% interest rate but charges fees at 6% of the loan amount ($900), those extra fees would bring the APR to 9.22% and the total cost of the loan to $19,308—a significant difference.
That’s why it’s important to look beyond interest rates. APR lets you make an apples-to-apples comparison between loans so you can see which loan is a better value, and how it will fit into your budget.
How are interest rates calculated?
Many factors are used to determine your interest rate, such as your credit history, application information, and the term you select.
Lenders see credit scores as an indication of creditworthiness. The higher your score, the more likely you are to pay back your debts. You might be able to lower your interest rate by boosting your credit health—though it will take time. Here are some steps you can take:
- Pay your loans and credit card bills on time.
- Don’t use too much of your available credit.
- Pay down debt.
- Don’t apply for new loans right before applying for a mortgage or other loan.
If you are considering a Discover® personal loan, keep in mind that the majority of Discover cardmembers get a better rate than non-cardmembers.
How is APR calculated?
To calculate APR, lenders factor in things like:
- Interest rate: The amount of money you pay to borrow the loan principal.
- Finance charges: These might include prepaid finance charges, points, and other fees.
- Fees: Many lenders add fees on top of the interest rate they charge for loans. Most often, these include loan origination fees and closing costs. Depending on the lender and the type of loan, other fees, like prepayment penalties, could apply. A personal loan from Discover doesn’t come with any of these fees as long as you pay on time, helping to keep your APR in line with your interest rate.
- Other factors: Your APR can also be affected by your loan’s origination date and when the first payment is due.
How can you use APR and interest rates to help you choose a loan?
As with any financial decision, make sure to get all the facts. Remember: APR is the total cost of borrowing, and it includes up-front fees and other charges. It’s a better, more complete picture of how much a loan costs than interest rates alone.
So always consider both interest rates and APR when you’re comparing lenders.
Discover Personal Loans doesn’t charge loan origination fees, or any other fee if you make your monthly payments on time. That means that your interest rate is also your APR. There are no other hidden fees.
The bottom line
Because interest rates and APR both come into play when shopping for a loan, it can be easy to confuse the two. But there are important differences.
While interest rates are part of understanding how much a mortgage or loan will cost, they don’t tell you everything. APR gives you a fuller picture of the total cost of a loan. With this information, you’re in a better position to find a loan you can afford and choose the terms that will fit within your budget.