If you’re in the market for a credit card or loan, you’ll likely see a bunch of terms thrown around that may be new to you.
You might wonder “What is APR?” or “What does APR mean?” Or, you may want to know: “What is the difference between interest rate and APR?”
It can be confusing.
To make things easier, we’ve broken down the differences between APR vs. interest rate. This way you’ll know the similarities and differences between these two terms. Read on to learn more.
What is APR?
But how does APR work? Although it’s similar to an interest rate, APR also includes additional things like fees that cover the total cost of the loan. In many ways, an APR give you the most accurate representation of your true borrowing cost.
The Truth in Lending Act states that APR must be determined in a specific way, adhering to certain rules and regulations. Nonetheless, lenders often offer a range of APRs. Borrowers with good credit can get the lowest rates, while those with poor credit will get the highest rates. Lenders protect their level of risk by charging higher rates to those who don’t have great credit. Annual Percentage Rates can be variable or stay fixed.
What Are Interest Rates?
You might be more familiar with the term interest rate.
Interest rates refer to the percentage a lender charges the consumer to borrow money. Your monthly payments are based on the interest rate, which are set in the promissory note that you sign at the beginning of your loan term.
Interest rates can vary depending on the type of loan and may be variable or fixed. Variable interest rates can change depending on the market, while fixed interest rates stay the same.
Additionally, the rates can vary depending on a borrower’s credit as well as economic factors, like federal interest rates. If you have good credit, you’ll likely get approved for a better interest rate. If you have poor credit, you’ll likely be stuck with a higher interest rate.
Why Understanding APR and Interest Rates Can Save You Money
Some people think that APR and interest rates are interchangeable, but they’re not. Interest rates will give you a general idea of how much it will cost to borrow money whereas APR gives you the big picture, with actual costs. Knowing the difference between these terms can save you big money.
The Annual Percentage Rate on a loan, for example, covers all added fees and additional costs.
Let’s take a look at this example from personal finance site, NerdWallet. This example is assuming you’re applying for a $5,000 personal loan with a repayment term of four years.
You can see that the interest rate and APR are close but not the same. You can also see that the APR is a bit higher, which is inclusive of all fees. In this scenario, the monthly payments are nearly identical, but Lender 1 offers a lower APR, which typically means it would be less expensive overall.
Knowing the APR and not just the interest rate is especially important when looking at mortgage loans. If you fail to review the APR and just look at the interest rate, you may end up paying thousands of dollars in unexpected costs.
Credit Card Loans
Credit cards are a bit tricky in that many credit card issuers use the terms “interest rates” and “APR” interchangeably. APR is how credit card interest rates are advertised, yet you need to be careful so that you don’t get stuck paying additional fees. There are cash advance fees, annual fees, balance transfer fees, and foreign transaction fees. So, read through the terms and conditions to understand credit cards fees.
When it comes to interest rates and APR, there are several factors that come into play.
Economic factors and the Federal Reserve play a large part in setting interest rates. Typically when the Fed increases interest rates, lenders follow.
Your creditworthiness also plays a role in determining what interest rates or APR you’ll get approved for. Your credit score is the three-digit number that can help you access the best rates — or leave you with the worst rates. When it comes to your credit score, your payment history carries the most weight (35%). On top of that, your credit utilization – or the amount of credit you use relative to your spending limit – is an important factor and makes up 30 percent of your credit score.
Your length of credit history, credit mix, and new credit all affect your credit score as well. Keeping accounts open and in good standing is one of the best things you can do for your credit. If you have various types of loans like student loans and car loans, that can look attractive to a lender as well — if you’re in good standing. But you also want to be careful with how many new credit lines you apply for or else you’ll look like a risk.
As you can see, there are a number of factors that determine the rate you’ll get. Keeping your finances in good shape and your credit healthy can help you get the best rates and save money on interest.
If You’re Fuzzy on APR vs. Interest, Speak Up
Whether you’re applying for a mortgage, a new credit card, a car loan or a personal loan, do your research and understand the difference between the interest rate and APR. Looking at the nuances can help you save money and make smart financial decisions.
If you’re confused about APR vs interest rate, speak up and ask questions. You can talk to a financial professional or the lender to make sure you understand how the interest will affect you. This, in turn, will help you make a financially responsible decision.