Interest rates and APRs play a huge role in determining the total cost of borrowing money, but what is the difference between APR and the interest rate on a loan? Both the interest rate and APRs are expressed as a percentage. Still, they represent different charges on a particular loan or line of credit. If you are looking into getting a personal loan, mortgage loan, credit card, or another form of funding, it is important to understand the difference between APR and interest rate.
What Is a Loan’s Interest Rate?
The interest rates are the cost of borrowing money. When borrowers are approved for loans, lenders look at their principal and use this amount to calculate how much interest fees borrowers must pay. Interest charges are then broken up into a given repayment schedule that borrowers pay in tandem with paying back their original loan amount.
Knowing the interest rate on a loan is crucial, especially for larger loans like a mortgage. Surprisingly, a survey found that one in four Americans don’t know their mortgage’s interest rate!2 However, you don’t have to be a part of that group; continue reading.
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 Interest Rate
Fixed interest on a loan means the rates will not change with each month. Fixed-rate loans are the most common.1 Instead, with these loans, 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
A variable interest rate on a loan means that rates may change each month. These loans can be called adjustable-rate loans or variable-rate loans. Borrowers who can handle some financial inconsistency may enjoy variable rates since they may save money and pay less interest fees for some months. However, they may be subject to varying market rates, so they may have to pay extra for some months.
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 cost them extra when borrowing. With loans that have a compound interest rate, the borrower may end up paying more and more with each monthly payment.
Simple Interest Rate
Simple interest is calculated based on the initial principal, which doesn’t change throughout the loan. This means the interest expense is constant and is not charged on previously accrued interest. As a result, for the same rate and duration, borrowers typically pay less with simple interest compared to compound interest financial products. You’ll find simple interest with most installment loans, including bad credit loans and personal loans.
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. They are usually broken down into monthly installments, which borrowers pay back over the course of their loan term.
Calculating APR
The APR is calculated using several factors of a loan, including a loan’s interest rate. The APR is expressed as a percentage; by law, lenders must tell you the APR when you apply for a loan. Because one borrowing option can have more loan fees built into it, APR standards can vary depending on the loan you are inquiring about.
Comparing a personal loan and a home loan may be helpful:
| Included in Personal Loan APR (Generally) | Included in Mortgage APR (Generally) |
| – The loan’s interest rate | – The mortgage interest rate |
| – Origination fee (most loan origination fees are a small percentage of the loan amount) | – An origination fee (origination fees with mortgages tend to be included with closing costs, like many other fees on this list) |
| – Prepayment fees (if any) | – Discount points/Mortgage points (discount points can be paid for to get a reduced interest rate) |
| – Late fees (which only occur if you miss a payment on your loan) | – Broker Fees (if you use a mortgage broker, you might have to pay broker fees for their services) |
| – Balloon payment (if any) | – Mortgage Insurance (mortgage lenders may require first-time buyers to have this) |
| – Additional fees (if any) | – Closing Costs (closing costs include costs like the down payment, appraisal fee, and other costs listed above) |
| – Prepayment Penalties (if any) | |
| – Additional fees (if any) |
Why is APR Important?
One question you may want to ask when comparing a loan’s Annual Percentage Rate (APR) and interest rate is why APR is important? APR is important for a few different reasons:
The interest rate represents only the cost charged on the principal balance (the loan amount you are borrowing) and no other fees. In contrast, a loan’s APR shows the true cost of borrowing funds.
- A loan’s APR makes it easy to estimate monthly payments.
- Comparing Annual Percentage Rates can be a great way to compare lenders, loan options, and loan terms, especially if the loans have the same interest rate and rules for repayment.
- Knowing the APR can help borrowers accurately plan with their money. It provides a more precise estimate of the yearly cost of a loan, helping individuals manage their personal finance habits.
Different Kinds of APR?
Here are some different types of APRs:
- A Fixed APR is a stable rate that remains unchanged throughout the duration of the loan or credit agreement. It has the same pros and cons as variable interest rates (mentioned above).
- A Variable APR fluctuates based on underlying benchmarks.
- Introductory APR is a promotional tool used predominantly by credit card companies. This temporary rate is lower than the card’s regular APR, with some promotions even offering a 0% rate.
How To Get the Best Interest Rate and Annual Percentage Rate When Borrowing Money
Below are a few tips on how borrowers can work towards receiving a better deal for loans and other financial endeavors.
Comparing Loan Offers and Lenders
Before filling out a loan application, research the different financial products and lenders available in your area. Start by looking at several different lenders and comparing each loan’s approximate interest rate, APR, and payback terms.
Improve Your Credit Score
Improving your credit can take time, but it can be the most effective way to get a better interest rate and APR. Here are some tips:
- Work on Your Payment History
- Focus On Paying off Debts
- Improve your credit mix
- Keep your credit accounts open
- Avoid Unnecessary Credit Applications
Put Down A Bigger Down Payment (For Applicable Loans)
If you can afford it, a larger down payment can lower your loan amount, thus potentially securing a better interest rate and APR. You’ll also likely have a lower monthly payment.
FAQs on the Difference Between APR and Interest Rate
Here are some FAQs on both the APR and interest rate that hopefully will help you understand the topic of APR vs. interest rate better:
Great question! The “prime rate” is the interest rate banks offer to their most creditworthy customers, usually big corporations. This interest rate is often used as a base for setting interest rates for various types of loans and credit cards. When you hear news about the prime interest rate going up or down, it often means other interest rates might shift, too!
The “daily periodic rate” is the interest rate you pay on a credit card or loan, broken down into a daily amount. Regarding your APR, it is your APR divided by the number of days in the year. This rate is used to calculate the interest you owe based on your daily balance. Think of it as the daily “cost” of borrowing.
Auto loan APRs can vary widely based on factors like your credit score, the loan length, and even where you’re buying the car. Generally, auto loans can have competitive rates because the car itself serves as collateral for the loan.
Often, these are promotional interest rates and APRs with credit cards are meant to attract new customers. The 0% APR usually lasts for a limited period, like 12-18 months. Once that period ends, the APR will jump to a higher standard rate. Also, check for potential fees or charges and make payments on time; otherwise, that promotional rate might end prematurely.
Credit cards often list several APRs because different types of balances on the card can have different rates. For instance, purchases might have one APR, cash advances another, and balance transfers yet another.
A few factors will affect the interest rate you can get on a loan when you borrow money. One of the most important is credit scores. Unfortunately, having a bad credit score may affect what interest rates you may qualify for.
Zero money down loan offers allow borrowers to access funds or other goods without paying interest costs, origination fees, or other charges upfront. While this may seem like a huge convenience, it can cost you more money in the long run, especially regarding the interest rate.
The Bottom Line: APR vs. Interest Rate
Understanding the nuances of borrowing money is crucial for financial success and informed decision-making. The main difference between APR vs. interest rate when you borrow money is that while interest rate simply represents the cost of borrowing the principal amount, the APR gives a comprehensive view, accounting for all fees and charges associated with the loan.
Equipping oneself with knowledge about these key terms not only safeguards against hidden costs but also empowers borrowers to choose the most cost-effective lending solutions. Always remember informed borrowing today leads to a financially stable tomorrow. Let CreditNinja guide you every step of the way.
References:
- Types of Interest Rates | Wall Street Mojo
- 1 in 4 Americans don’t know the interest rate on their mortgage: Survey | CNBC
- 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
