APR and interest rate are two common banking terms that can be confusing. What’s the difference between the two? Aren’t they the same?
While some people may use the two terms interchangeably, interest rate and APR refer to different things, although they are related. When you take out a loan, pay attention to both the interest rate and the APR to get a clearer picture of what you’ll pay to borrow money.
Keep reading to learn more about the difference between APR and interest rate, plus how a lender calculates each percentage.
What is an interest rate?
An interest rate is the amount you pay to borrow money from a lender. All types of loans, including mortgages, car loans, student loans, and personal loans, come with an interest rate predetermined at the start of the loan.
As you repay the loan, you’ll pay both principal and interest.
- Principal refers to the amount of money you’re borrowing.
- Interest is the cost to borrow that amount.
- The loan term is the number of months or years you have to repay the loan.
- For example, you might borrow $300,000 to buy a house with a 30-year mortgage. With an interest rate of 7.5%, you could expect to pay $424,680 in interest over the loan term for a total amount paid of $724,680.
If you take out a $30,000 loan to buy a car with a 7% interest rate and a 5-year term, you could expect to pay around $5,600 in interest.
Although your payments will stay the same for the loan term, more of your money will go toward interest at the beginning of the loan, and by the end of the loan, you’ll mostly be paying down the loan principal. This is called amortization.
Want a deeper understanding? Learn more about interest rates and your money.
How are interest rates calculated?
Knowing the definition of an interest rate is only one part of the puzzle. You also need to understand how interest rates are calculated.
Interest rates are calculated using several factors, most of which are outside your control. The most significant factor is the economy and federal interest rates, which usually determine the range of interest rates a lender will offer. Because federal interest rates fluctuate frequently, loan interest rates change daily or several times within the same day.
However, your interest rate will also depend on factors within your control, like your credit score. You will likely be offered a lower interest rate if your credit score falls in the “good” or “excellent” range. Conversely, a “fair” or “poor” credit score usually means you’ll get a higher interest rate or even a loan application rejection.
Other factors lenders consider include:
- Your debt-to-income (DTI) ratio: The amount of debt you have in relation to your monthly income can help a lender determine how risky it is to approve your loan or credit card application. A high DTI ratio can equal a higher interest rate.
- Your down payment: For loans, a higher down payment means you have more equity in the home or car you’re buying from the start, which makes you less likely to default. This can result in a lower interest rate.
- The loan term: A shorter loan term may result in a lower interest rate, though this isn’t always the case. Check with your lender to see if you can qualify for a lower rate by opting for a shorter loan.
The interest rate you are offered can also differ from lender to lender, so it pays to shop around for a loan.
Read more about how interest rates work.
What is APR?
APR stands for annual percentage rate. This number refers to the loan’s interest rate and fees. APR gives you a clearer picture of how much you can expect to pay each year in interest and loan fees.
Some examples of the fees included in a loan’s APR include:1
- Origination fees
- Closing costs
- Mortgage Insurance
- Mortgage points
- Broker fees
- Prepaid interest
APR applies to any loan or line of credit, such as a credit card. However, in most cases, the APR and interest rate on a revolving line of credit, such as a credit card or a home equity line of credit, are the same.
Read more about APR on a credit card to better understand how this term applies.
How is APR calculated?
Lenders calculate APR by adding the fees associated with borrowing money to the loan’s or credit card’s interest rate. This gives you a clearer picture of how much you will pay monthly.
For example, a home loan of $250,000 with a 7% interest rate may have $7,500 in fees, including origination fees, closing costs, and mortgage points. Those fees are added to the loan for a total of $257,500.
From there, you can calculate the annual payment by multiplying the total loan amount, including fees, by the interest rate of 7% for a total of $18,025. Finally, divide the annual payment by the original loan amount to get an APR of 7.21%.
The APR is usually higher than the interest rate (except for credit cards, where the interest rate and APR are typically the same).2 Reviewing the interest rate and the APR to determine which is best for you makes sense when considering loan options.
What is the difference between APR and interest rate?
The main difference between APR and interest rate is what the percentage represents. Interest rate is self-explanatory; APR includes the interest rate and any associated loan fees.
If you’re shopping around for a loan, comparing interest rates doesn’t give you a complete picture of your costs – but comparing APR will.
|A percentage of the loan amount that you pay in exchange for borrowing money
|The interest rate plus any fees associated with the loan, such as closing costs, expressed as a percentage
|A lower percentage that doesn’t include fees
|A higher percentage that includes loan fees
|Doesn’t give a complete picture of the cost of borrowing money
|Gives a clearer picture of what you’ll pay to borrow money
Consider both APR and interest rates when shopping for a loan
When taking out a loan, review both interest rates and APR. Do this whether you need a loan to buy a home, replace your car, pay for college, or consolidate debt.
If you only consider a loan’s interest rate, you’re not fully understanding what you will pay each month. By considering APR, you can more easily fit loan repayment into your monthly budget without unpleasant surprises.
Want to know more? Learn about the difference between APR and APY (annual percentage yield) to deepen your understanding further.