Table of Content
- The interest rate represents the cost of borrowing money, expressed as a percentage. However, the interest rate does not include other types of costs and commissions associated with borrowing money.
- The Annual Percentage Rate, also known as APR includes the interest rate plus other costs such as origination fees, document fees, and other types of expenses the client has to pay to borrow the money.
- The Federal Truth in Lending Act requires lenders to always disclose the Annual Percentage Rate in all loan documents.
Interest Rate Vs. APR: How They Compare?
If you’re in the market for a mortgage, credit card, or personal loans, might find all the financial terminologies as mumbo jumbo.
Two phrases stand out in the most confusing category: annual percentage rate (APR) and interest rate. In the same way as knowing the difference between a fixed-rate and an adjustable-rate mortgage loan, knowing how an APR and interest rate difference is important.
If, right now, you can reasonably distinguish the two, welcome to the club. However, once you learn the difference between these two figures, you’ll be more confident to begin shopping for a loan.
What Is An Annual Percentage Rate (APR)?
An APR is the cost of credit expressed as a yearly interest rate. It includes the interest rate, fees, and other costs associated with a loan, expressed as a yearly rate.
The APR is one of the main considerations you can use when choosing a bank to work with, especially when considering getting a mortgage. Mortgages are more complicated, so you’ll need more knowledge about the subject.
The APR helps consumers compare the costs of different loans by considering the total cost of borrowing over the life of a loan. APR is therefore a broader and more comprehensive measure of the cost of credit, while interest rate is a narrower measure that only considers the interest component.
How Does Interest Rate Work?
Basically, the amount of money you borrow is your loan's principal. The interest rate you pay to the lender is the interest on this principal.
The interest rate is the cost you pay to the lender for letting you borrow the money. When we talk of a mortgage loan, you can choose between a fixed-rate mortgage or an adjustable-rate mortgage.
The interest rate is purely for the cost of borrowing money, and it takes care of only the principal. It does not include charges like origination fees, closing fees, documentation fees, other finance charges, and other similar fees that the lender might ask you to pay.
Why APR Is Higher Than Interest Rate?
On the other hand, the annual percentage rate is a wider measure of all the costs involved in borrowing money and they express it as a percentage rate as well.
Simply put, the APR will include primarily the interest rate plus all other points, broker fees, origination fees, documentation fees, and other charges that you pay in connection with the loan. With all this input, you can see that your APR will be higher than your loan interest rate. The APR provides a clearer picture of what you’re really paying for your loan.
Let’s say that you get a loan of $1,000 – then your principal is $1,000. The lender says you have to pay an interest of 8 percent per annum. The interest is what you pay for the principal. Therefore, the interest that you owe to the lender for the $1,000 loan is $80.
Since the interest rate is just part of the APR, you can safely say that the APR would always be higher than the interest rate. The rule of thumb is the closer the two rates are to each other, the better the loan deal for the borrower.
Lenders Must Expose APR
The Federal Truth in Lending Act protects the borrower by requiring that all consumer loan agreements divulge the APR. And since this law guides all lenders to follow the same rules to preserve the accuracy of the APR, borrowers can use the APR to compare loans. Remember that your monthly payment will depend on the interest rate on your promissory note and not on your APR.
Compute and compare thoroughly the rates that lenders offer. Compare one lender’s APR to another loan provider’s APR for a more accurate comparison. And don’t skip the comparison of interest rates, too.
How Interest Rate And APR Work On Credit Products
Interest rate and APR are used to calculate the cost of borrowing for various credit products, such as mortgages, personal loans, credit cards, and auto loans.
Let's see how does it works on each of them:
With credit cards, the interest rate and the APR are the same.
APR on a credit card is the annual percentage rate charged for borrowing money using the credit card. It represents the cost of borrowing expressed as a yearly interest rate and takes into account not only the interest rate but also any other fees and charges associated with using the credit card, such as cash advance fees and balance transfer fees.
The APR is used to help consumers compare the cost of different credit cards and to understand the true cost of borrowing when using a credit card.
When it comes to credit cards, they are interchangeable. There is no origination fee with credit cards, and many other fees are optional on the cardholder's part. The annual fee, although a mandatory fee whether or not you use your card, is not a cost that you can associate to borrowing money. Therefore, it is not part of the APR.
If you carry a balance rather than paying everything in full every month, you should know how much interest the card company will charge you. If you carry debt, remember that the APR only includes the interest rate but does not reflect the cost of compound interest.
A good credit card APR is subjective and depends on the individual's financial situation and needs. Generally, a lower APR is considered to be better because it means you'll pay less in interest charges over the life of the loan.
A credit card APR can range from around 10% to over 30%, so it's important to compare APRs from multiple card issuers to find the best one for your needs.
Additionally, some credit cards offer introductory APRs that are lower than the standard APR, but only for a limited time, so it's important to understand the terms and conditions of the card and the APR after the introductory period.
Chase Sapphire Preferred® Card
2X – 5X 5x total points on travel purchased through Chase Ultimate Rewards, 3x points on dining and online grocery purchases and 2x on other travel purchases. Plus, earn 1 point per dollar spent on all other purchases
20.49% – 27.49% variable APR
American Express® Gold Card
1X – 4X 4X points at restaurants (including Uber Eats purchases in the U.S.) and U.S. supermarkets (up to $25,000 per year in purchases, then 1X points), 3X points on flights booked directly with airlines or on amextravel.com, 2X points on rental cars through amextravel.com and 1X points on all other purchases
20.49% – 28.49% Variable
Bank of America® Customized Cash Rewards Secured Credit Card
1% – 3% 3% cash back in the category of your choice: gas, online shopping, dining, travel, drug stores, or home improvement/furnishings,2% cash back at grocery stores and wholesale clubs, unlimited 1% cash back on all other purchases
18.24% to 28.24% will apply. A 3% fee (min $0) applies to all balance transfers
Capital One Venture X Rewards
1X – 10X 10 miles per dollar on hotels and rental cars when booking via Capital One Travel, 5 miles per dollar on flights and 2 miles per dollar on all eligible purchases
21.24% – 28.24% (Variable)
Capital One SavorOne Cash Reward
1% – 3% earn unlimited 3% cash back on dining, entertainment, popular streaming services and grocery store purchases (excluding superstores like Walmart® and Target®), 1 percent on all other purchases.
19.24% – 29.24% variable
1X – 2X 2 AAdvantage miles per dollar on grocery stores and eligible American Airlines purchases, and 1 mile per dollar on other purchases
20.49% – 29.49% (Variable)
1X – 10X 5X total points on air travel and 10X total points on hotels, car rentals when you purchase through Chase Ultimate Rewards®, immediately after earning your $300 annual travel credit. Also, earn 3x points on dining at restaurants and travel (after meeting the $300 travel credit), then 1x points per dollar spent on all other purchases
21.49% – 28.49% variable APR
1X – 5X 5X points on up to $500,000 spent on directly-booked airfare and flights and prepaid hotels booked through American Express Travel (per calendar year), 2X points on prepaid car rentals through American Express Travel and 1X points on all other purchases
20.49% – 27.49% Variable
Personal loans typically have an interest rate and an APR. The interest rate is the cost of borrowing expressed as a percentage of the loan amount and is used to calculate the interest charged on the loan.
The APR takes into account not only the interest rate but also any additional fees and charges associated with the loan, such as origination fees, to give a more accurate picture of the true cost of borrowing.
When considering a personal loan, it's important to compare APRs to better understand the total cost of the loan and find the best loan for your needs.
You can use the APR to determine the actual cost of your mortgage. You don’t just only consider the interest rate but all the points, mortgage origination fees, and other costs that come to be able to get a loan.
You’ll see that the APR is sometimes many times higher than the interest rate because of all the other loan costs that the lender throws in on the loan.
There is one thing that you should note, though. The lenders might not include all fees in the APR. The law does not require them to include certain costs such as credit reporting, appraisal, and inspection fees.
For a more accurate costing, ask your lenders what they will include in the APR and what they won’t. This way, when you make your comparison, you’ll have a better idea of the real cost of each lender.
Let’s look at the three examples below and let’s try to see the effects of the different components on the APR. The loans are for $250,000 with a term of 30 years and a fixed interest rate.
The first has a rate of 4.75%, the second 4.5% and the third, a slightly lower rate of 4.25%. We’ll be able to see the difference in terms of APR and how the different parameters impact the total cost of the mortgage loans.
|Total closing cost||$3,500||$6,000||$8,500|
|Total after 10 Years||$156,494||$152,005||$147, 580|
|Total after 30 Years||$469,481||$456,018||$442,7456|
APR vs Interest Rate: Which Should I Use?
It’s easier to compare loans among lenders when you use the interest rate and the APR. Lenders usually start with the basic interest rate for their quote so you can use that for a quick comparison between loans.
Nevertheless, it is the APR that will tell you the true cost of the loan (especially for a short-term loan). APR is more comprehensive in a sense that it includes the other costs and fees that come with borrowing money, plus your repayment terms.
How To Calculate APR On Loan?
APR (Annual Percentage Rate) is the annual cost of credit, including both interest and any fees, expressed as a yearly rate. To calculate the APR, you need to consider the following factors:
Interest rate: The interest rate is the percentage charged by the lender for borrowing the money.
Loan fees: APR includes any fees charged in addition to the interest rate, such as origination fees, closing costs, and other fees.
To calculate the APR, you can use the following formula:
APR = ((Interest + Fees / Principal or Loan amount) / N or Number of days in loan term)) x 365 x 100
Note that this is a simplified calculation and may not be 100% accurate. It's always a good idea to confirm the APR with the lender or to use an online APR calculator to get a more accurate estimate. Additionally, it's important to understand that the APR is not the same as the interest rate, as it takes into account the total cost of borrowing over the life of the loan.
Example: How To Calculate APR On Loan?
Let's take the following example:
- Loan: $10,000
- Term: 5 years (monthly payment)
- Interest Rate: 7%
- Fees: $1,000
Based on these details, here are the final payments:
- Amount Financed: $10,000
- Upfront Out-of-Pocket Fees: $1,000
- Payment Every Month: $197
- Total of 60 Payments: $11,819.94
- Total Interest: $1,819.94
- All Payments and Fees: $12,819.94
Now, let's work according to the formula:
Interest + fees = 2,819, the principal is $10,000 and the number of days is 1,825.
If you place it in the formula we can see the APR is 11.292%
Easy And Simple Way: Use a Loan Calculator
You can (or should) use a loan calculator yourself to make some computations, including the effective interest rate if you have to. Don’t lock yourself into a high-priced business loan because you just looked at the lowest monthly payments or the cheapest interest rate.
You should remember that these low-number figures aren’t all there is – there’s a lot more to consider, especially if we are talking about long-term loans such as a mortgage or when applying for a new credit card. Use the APR as a gauge to ensure you’re getting the lowest-cost financing among many lenders. It’s the most transparent and inclusive means to tell you how much you’ll be paying for your loan.