You might be confused by the terms interest rate and APR or you may think they are interchangeable. Learning the difference between them might help you choose a personal loan that could save you thousands of dollars. We’ll look at each term to help you learn what the difference is between APR and interest rate.
What is an Annual Percentage Rate (APR)?
An Annual Percentage Rate is a comprehensive measure of what you’ll pay back over the life of the loan. APR takes into account each of the following:
- Your interest rate: The amount of money you owe for borrowing the loan principal.
- Other finance charges: These might include prepayment charges 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. Discover Personal Loans, for example, doesn’t charge borrowers loan origination fees or any other fees as long as you make your monthly payments on time. Therefore, those fees do not impact your APR for a Discover Personal Loan, but the APR may still differ from the interest rate depending on other factors, such as when the loan is disbursed and when the first payment is due.
What is an interest rate?
Interest rates tell you the periodic cost of borrowing the principal (the funds borrowed) from the start to finish of the loan, expressed as a percentage applied to the loan balance 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. Depending on the lender, some loans have fixed interest rates while others have variable rates. Lenders such as Discover Personal Loans have a fixed interest rate on loans, meaning it won’t change and future payments will be easier to plan. You can even see what your rate will be before you borrow.
Why we need both the APR and the interest rate
An interest rate is commonly expressed as a yearly percentage, which can lead to confusion with the APR. And it’s no wonder. An interest rate expressed as a yearly percentage compared to a percentage rate that’s calculated annually sounds like the exact same thing. So it’s understandable for borrowers to wonder why there’s a need for both interest and APR.
Here’s why. While they are similar, each has its own function within your loan. An interest rate calculates the periodic cost of borrowing the principal (the set amount of money) during the lifetime of a loan. An annual percentage rate (APR) is your base interest rate plus any additional charges for securing the personal loan which is then calculated as an annual rate. Even if the lender does not charge any upfront fees, the APR may still differ from the interest rate depending on other factors, such as when the loan is disbursed and when the first payment is due.
You’ll likely have heard about how each applies to different forms of financing; credit cards, mortgages, etc. Let’s look within the context of personal loans.
How a personal loan interest rate and APR are determined
There are multiple factors that determine a borrower’s approved interest rate and APR:
- Credit score
- Loan amount
- 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 should you choose your loan?
When shopping for any loan, be sure to crunch the numbers. It may be helpful to view annual percentage rate as the total cost of borrowing, including up front fees, instead of just considering the interest rate being applied to your personal loan. Ideally, 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 loans among lenders. What looks like a few percentage points can mean big savings over the life of your loan.