Interest Rates

What Is the Difference Between APR and Rate?

Interest rates and APRs play a huge role in determining the total cost of borrowing money, but what is the difference between APR and rate of interest on a loan? Both the interest rate and APRs are expressed as a percentage, but they represent different charges on a particular loan or line of credit. 

How much interest lenders may charge on a loan or line of credit depend on financial factors like the borrower’s credit history, debt-to-income ratio, as well as current market conditions. If you are looking into getting a personal installment loan, mortgage loan, credit card, or another form of funding, it is important to understand the difference between APR and interest rate. 

What Is an Interest Rate on Loans?

The interest rates charges are essentially the cost of borrowing money. When borrowers are approved for loans, lenders will take a portion of their principal balance and use this amount to calculate how much in interest fees borrowers are required to pay. Interest charges are then broken up into monthly installments that borrowers pay in tandem with paying back their original loan amount.

Depending on the type of loan, other fees borrowers may have to pay in addition to interest rate charges are: 

  • Loan origination fees.
  • Mortgage broker fees. 
  • Discount points. 
  • Closing costs or mortgage insurance fees (if you are working with mortgage lenders). 

How Are Interest Rates Calculated When You Borrow Money?

Wondering how to calculate interest on a loan? Before you start, you will need to identify the type of interest rate your loan has. There are several different types of interest rates you may generally receive on a loan; they are: 

  • Fixed rates. 
  • Variable rates. 
  • Simple rates. 
  • Compound rates. 

Fixed Interest Rate

Fixed interest on a loan means the rates will not change with each month. Instead, borrowers are charged a consistent monthly rate that results in equal monthly payments. Personal loan interest rates are often calculated using fixed interest. 

Variable Interest Rate

Variable interest on a loan means that rates may change with each month. Borrowers who are able to handle some financial inconsistency may enjoy variable rates since it means they may get to save money and pay less in interest fees for some months. However, borrowers are also subject to varying market rates when they have variable interest on a loan, which means they may have to pay extra for some months. 

Simple Interest Rate

Simple interest rates are calculated using your current loan balance. Since interest is charged based on the current balance and not the original principal amount, borrowers should end up paying less over time on simple interest financial products

For example, say you had a $100 loan with a 5% simple interest rate. Interest for your first monthly payment would be calculated using the full $100 principal balance, bringing your total to $105. If you made a payment of $55, interest for your next month’s payment would be calculated using your current $50 balance, not the original $100 amount. 

Compound Interest Rate 

Compound interest is often referred to as “interest on interest.” This phrasing refers to the fact that financial products with compound interest use previous interest charges when calculating a consumer’s new monthly rate. Compound interest rates generally work in a consumer’s favor if they are investing but may end up costing them extra when borrowing. For example, some bank or savings accounts reward consumers with compound interest if they do not make any withdrawals from their accounts. If you abided by those conditions, you should end up with an increasing amount of money in your account with each passing month. 

But with loans that have compound interest, the borrower may end up paying more and more each month. For example, say you had a $100 loan with a 10% compounded interest rate. After your first month, you would accumulate $10 of interest bringing your total loan balance to $110. The following month your compound interest would apply to both the $100 principal loan amount as well as the $10 of accumulated interest from the previous month, and so on. 

What Does Annual Percentage Rate Mean on a Loan?

The annual percentage rate (APR) reflects the amount of money borrowers will pay in interest over the course of a year. APRs are usually broken down into monthly installments, which borrowers pay back over the course of their loan term. 

What Does Zero Money Down Mean?

Zero money down loan offers allow borrowers to access funds or other goods without having to pay interest costs, origination fees, or other charges upfront. Instead, borrowers are able to gain access to their funds or goods right away and start making payments on it later. Everything from a home, vehicle, or even a piece of furniture can come with zero money-down purchasing options. 

While on the surface, putting zero money down on a large purchase may seem like a huge convenience, it can end up costing you more money in the long run, especially when it comes to interest rates. Since interest rate charges are often calculated using the borrower’s current balance, the more money you owe, the higher your interest fees may be. When you make a big purchase or borrow money and put zero money down, you are leaving a large amount left over for lenders to charge interest fees with. You are most likely better off with making a down payment, even if the lender/seller does not require it. 

How Does Interest Work on a Revolving Line of Credit?

It is important to note that revolving lines of credit and loans work differently with it comes to interest rates. The way credit card APRs and interest rates work is that borrowers are only charged interest on the amount of money they spend, not their entire credit limit. Traditional loans will charge interest on the entire approved amount, regardless of how much of it the borrower spends. 

How Do I Know What Interest Rate I’ll Get on a Loan?

There are a few factors that will affect the interest rate borrowers can get on a loan. One of the most important are credit scores. Unfortunately, having a bad credit score may affect what interest rates you may qualify for. Other factors that go into determining interest rates are: 

  • Credit history. 
  • Income. 
  • Current credit utilization. 
  • Existing debts. 

How To Get the Best Interest Rates When Borrowing Money

Below are a few tips on how borrowers can work towards receiving a better deal on interest rates for loans and other financial endeavors. 

Research Lenders and Financial Products Before You Apply

Before filling out a loan application, do some research on the different financial products and lenders available in your area. Start by looking at several different lenders and comparing loan offers, interest rates, and payback terms. You can even start speaking with loan agents online or over the phone to get a loan estimate.

When doing your research, watch out for red flags like company inconsistency. For example, if you speak with a loan agent and they give you an estimate that has rates vastly different from the advertised interest rate on the lender’s website, you may want to look for funding elsewhere. 

Work on Your Payment History

When trying to improve your credit score in order to get better interest rates, one of the most impactful things you can do is work on your payment history. Every time you make a monthly payment on a loan or other financial obligation on time, lenders and credit bureaus see this as a sign that you are a responsible borrower. When you pay off debt with consistent monthly payments, you may find your credit score has risen significantly the next time you pull a report! 

Focus On Paying off Debts

Another way to improve your credit for better rates is to work on paying off your debts. Clearing up room in your debt-to-income ratio will free up room for lenders to approve you for additional credit. Furthermore, having less debt on your credit profile will encourage lenders to approve you for financial products that come with a more competitive interest rate. 

Avoid Unnecessary Credit Applications

If you are looking to boost your credit or maintain a good credit score, avoid applying for new credit cards or loans unless absolutely necessary. Every time you submit an application for a loan or other form of financing, lenders request a hard credit pull. Just one credit pull has the ability to lower credit scores by up to five points! While a one-time five-point drop may not be too difficult to recover from, submitting multiple applications within a short period of time can cause scores to drop quite a bit. 

The Bottom Line: Interest Rate and APR 

Interest rate charges are usually unavoidable when people borrow money, so it’s best to prepare for them if you are looking into getting a loan. You can make more frequent payments or pay more than your minimum amount due to save money on interest rates and other charges while you pay off your debts!  

References:
What Is the Difference Between APR and Interest Rate on a Personal Loan? | Experian
What are Interest Rates & How Does Interest Work? | credit.org
Interest | Internal Revenue Service