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Why is apr higher than interest rate

Why Is APR Higher Than Interest Rate

It is easy to get lost in financial jargon when you are attempting to borrow money. What is the difference between APR and an interest rate? Are they not the same thing? Why is one higher than the other? Etcetera, and so on. It can be confusing even for the best of us. When borrowing money, it is always wise to do your research beforehand so you can be fully informed of all the costs you will have to cover and why, from origination fees to the interest rate and APR. 

It is always a good idea to know precisely what you are getting into before taking out a loan particularly if you are getting a mortgage loan to buy your first home. We are going to break down what an interest rate is, how it differs from an annual percentage rate (APR), how each of them is calculated, and how you can save on the cost of borrowing money. 

What Are Interest Rates?

In their most basic definition, a loan’s interest rate represents the cost of borrowing money. An interest rate is how lenders make the majority of their profit. By calculating your interest rate, you will be able to determine the total amount of money you will pay for the loan. Interest rates can be fixed or adjustable depending on the loan. 

For example, when applying for a mortgage loan to purchase a home, you can get a fixed-rate mortgage loan with an interest rate that never changes throughout the duration of the loan. Or you can get an adjustable-rate mortgage in which the interest rate can change at certain intervals throughout the loan term based on market conditions.

What Is an Annual Percentage Rate?

APR is an acronym for annual percentage rate, which many people can use interchangeably with the term interest rate. APR reflects the total cost of your mortgage by including both the interest rate alongside some other fees and closing costs.

For example, a mortgage interest rate is not the same thing as the APR. Any loan origination fees, discount points, closing costs, or other fees are all included in the APR calculation so that it is easier for borrowers to know how much they are paying from the start of the loan. The Truth in Lending Act (TILA) requires that all mortgage lenders disclose the APR to borrowers.1 But, there are some lenders who do not include all fees in the loan’s APR. 

Some of the fees that mortgage lenders are not required to include in APR are credit reporting, appraisal, inspection, and mortgage broker fees. We recommend you ask the lender what is included so that you can have an accurate idea of how much your loan will cost.

What Is the Difference Between APR and Interest Rate?

Both the interest rate and APR are able to provide you with an idea of how much each loan will cost, so it is easier for you to compare and contrast different loans. The key difference between APR and interest rate is that the APR includes the additional fees that you will need to pay in addition to the interest rate. When searching for a mortgage, the APR will typically make a more accurate loan estimate. The APR tends to be higher, which is why the advertised interest rate is often just the interest rate without the fees included in APRs.

Below is a further breakdown of APR vs interest rates: 

FeatureInterest RateAPR (Annual Percentage Rate)
DefinitionRefers to the annual cost of a loan to a borrower, expressed as a percentage. Represents the annual cost of a loan to a borrower, including fees. Like an interest rate, it’s expressed as a percentage. 
Components Only accounts for the interest rate on the loan. Includes other charges or fees such as mortgage insurance, most closing costs, discount points, and loan origination fees. 
PurposeTo provide the cost of borrowing the principal amount. To give a more comprehensive understanding of the true cost of borrowing, including associated fees. 
RegulationNot always mandated for disclosure in loan agreements. The Federal Truth in Lending Act mandates that every consumer loan agreement disclose the APR.
UsageUsed to determine the monthly payment based on the interest rate on the promissory note. Used for comparing the total cost of loans, as it provides a broader perspective on the overall cost. 

How Are APR and Interest Rates Calculated?

Interest rates and APR are determined by a wide variety of factors, some of which are entirely out of your control. Interest rates go up and down depending on inflation, the broader economy, market conditions, and the lender you end up choosing. These factors are constantly changing, which is why mortgage rates are always fluctuating.

There are other aspects that you are within your control that play a part in calculating what your interest rates will be. Lenders will take your credit history, how big your down payment will be, your debt-to-income ratio, and other personal finance factors into account when determining your interest rate. A higher credit score will secure you a lower interest rate.  

Once the interest rate has been determined by the lender, the APR is calculated by adding on all the additional fees the lender wants to charge and subtracting whatever points you decide to pay upfront. 

Why Is APR Higher Than Interest Rate?

As the interest rate and APR are often confused with one another, it can be off putting when people see that the APR is higher than the interest rate they saw advertised for the loan they applied for. But, as we mentioned above, APR and interest rates are two different things. For example, mortgage lenders often include origination fees, discount points, and closing costs in the APR. Because of this, your loan’s APR will be higher than the interest rate. 

How To Save On An Interest Rate

How much interest you end up needing to pay on any loan you get approved for will depend greatly on your credit score. Subprime borrowers pose more of a credit risk to lenders than borrowers with a good or excellent credit score. Because of this, lenders tend to increase the interest rate they charge so they can make more of a profit to offset the possible loss they are risking by lending to poor credit borrowers. If you are looking to get a competitive interest rate on your mortgage, it might be a good idea to improve your credit score before applying for loans.

Improve Your Credit Score for Lower Interest Rates

When financial institutions such as banks set interest rates on your loans, they will almost always look at your credit reports and credit score. You can obtain significantly lower interest rates and APRs from mortgage lenders when you have a high credit score. You will also find you are offered a lower APR and interest rate on personal loans, auto loans, and introductory offers from credit card issuers. So, if you have the time to take it slow, we highly recommend putting in the extra effort to improve your credit score before you apply to borrow money.

Making a lasting improvement to your credit history takes some time and commitment but there is no doubt as to the benefits of a good credit score. The financial opportunities afforded to individuals with good credit are enviable and reason enough to devote your time and energy into improving your score. 

Here are a few tips and tricks for raising your credit score to gain access to better interest rates:

Look Over Your Credit Report Before You Borrow Money

To know what you most need to fix, you will need to look over your credit report and keep on checking it regularly. Learn how to identify what isn’t working and what you can do better in the handling of your credit accounts. Checking your credit report regularly will also allow you to catch any errors on your report and dispute them with the credit bureaus quickly before they have the chance to bring down your FICO score. 

Pay off Some of Your Debt

If you have a fair amount of debt, it would likely benefit your credit score considerably to pay down a significant portion of your debt. Particularly if you have a lot of credit card accounts, you likely have a high credit utilization ratio which can severely bring down your credit score. Dedicate time and energy to paying down the balances you owe, and you will likely see a positive change in your credit score. 

If you’re not sure how to get started on paying off your debt, we recommend looking into a tried and true repayment method to give you a roadmap. It could be a good idea to start with paying off higher-interest debt first, like no credit check loans. Some reliable strategies you could look into include the debt snowball method and the debt avalanche method. 

Make Payments on Time

Your payment history accounts for 35% of your credit score calculation, which is the most considerable portion of the FICO credit scoring model. To improve your credit score, you must not make any of your monthly payments late. Consistent, on-time monthly payments are the best way to keep your credit in good shape. If you have trouble remembering when your credit card bills are due, consider setting up automatic payments for each monthly payment on all of your debts before the due date, so you don’t make any more late payments in the future.

Take a Break From New Credit

When making efforts to improve your credit score, it is a good idea to take a break from filling out any more credit applications for the time being. Every time you fill out an application for new credit, you are authorizing the lender or credit card issuer to pull a copy of your credit report which results in a new hard inquiry. Too many hard credit inquiries in a short period of time can harm your credit. Taking a break from applying for any new credit products will give your credit the time it needs to improve.  

APR vs. Interest Rate When You Borrow Money: FAQ

Why do lenders use both APR and interest rates?

Lenders use both to provide a transparent view of the cost of borrowing. While the interest rate shows the basic cost of borrowing the principal amount, the APR gives a holistic view, including all fees and charges, allowing borrowers to compare loans more effectively.

Can the APR change after I take out a loan?

For fixed-rate loans, the APR is typically constant. However, for adjustable-rate loans or credit cards with variable rates, the APR can change based on the terms of the loan or changes in the underlying interest rate benchmark.

How does my loan term (e.g., 15 years vs. 30 years) affect the APR?

A longer loan term might have a lower monthly payment, but you could end up paying more in interest over the life of the loan. This can affect the APR, as the total costs spread out over a longer period might result in a different APR compared to a shorter-term loan.

Are there any loans where the interest rate and APR are the same?

Yes, if a loan has no additional fees or costs associated with it, the interest rate and APR could be the same. However, this is rare, as most loans have some form of fees.

How does refinancing affect my APR?

Refinancing can change your APR. If you refinance to get a lower interest rate or to extend/reduce the term of your loan, or if there are additional fees associated with the refinancing process, your APR will be recalculated based on these factors.

Is there a difference in how APR is calculated for credit cards vs. mortgage loans?

Yes, while the basic principle is the same (combining interest rate with fees), the specific fees and charges included can vary. For instance, credit card APR might include annual fees, while mortgage APR includes costs like origination fees and costs of closing.

How can I use APR to compare loan offers from different lenders?

APR is a valuable tool for comparing the true cost of loans from different lenders. A lower APR generally indicates a cheaper loan when all costs are considered. However, always ensure you understand the terms, potential rate changes, and any hidden fees not included in the APR.

A Word From CreditNinja

Knowing the difference between a loan’s APR and interest rate is essential when calculating an 

accurate repayment schedule on bad credit loans or any other type of funding. CreditNinja encourages all borrowers to calculate their loan to value ratio before agreeing to and signing their loan contracts. That way, you can create a financial plan on how you are going to repay you loan, and how long it should take. 

Looking for more resources on calculating interest rates and prepping your finances for a loan? Check out tons of free resources in the CreditNinja blog dojo! 

References:
1. APR vs. Interest Rate: What’s The Difference? | Capital One 
2. APR vs. Interest Rate: What’s the Difference? | U.S. News

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