APR vs. Interest Rate: What’s the Difference?

If you’ve ever applied for a loan and felt confused by all the financial jargon, you’re not alone. When shopping for a loan or mortgage, you’ll often hear two key terms thrown around: interest rate and APR. 

While they might seem the same, interest rate and APR actually represent two different costs associated with borrowing money.

Understanding the differences between APR vs. interest rate could save you thousands of dollars in the long run and help you make smarter financial decisions. Learn what each term means and how they’re calculated, along with some key differences. 

What is an APR? 

An APR (Annual Percentage Rate) is the total cost of borrowing money over a year, and it’s expressed as a percentage. 

APR includes the interest rate along with other fees and charges on a loan (like loan origination fees, closing costs, and mortgage insurance). 

This makes an APR a more complete picture of what you'll pay over time. 

How to calculate APRs 

Calculating an APR gives you a better idea of the true yearly cost of borrowing. While lenders usually do this for you, it’s helpful to understand how it works, especially when comparing loans. 

When comparing an APR vs. interest rate, APRs are calculated by adding other fees charged by the lender, such as a loan origination fee, to the interest amount. It lets you compare the cost of loan products on an “apples-to-apples” basis. 

Here’s a step-by-step breakdown: 

1. Add your loan fees + the total interest you’ll pay over the life of the loan. Depending on the loan type, these fees might include origination fees, closing costs, or mortgage insurance.
2. Divide that (interest + fees) by the loan amount to see how much you're paying compared to what you borrowed.
3. Divide that by the loan term, or the number of years you’ll be repaying the loan. This spreads the cost out annually.
4. Convert to a percentage by multiplying the result by 100. This is your APR. 

To see how this works, here are a few quick examples using real numbers. This will show how fees affect the APR and why it’s often higher than the interest rate alone. 

Example #1 

For a $10,000 one-year loan with: 

• Interest rate = 15%
• Origination fee = 5%
• Total interest for one year = $1,500
• Total origination fee = $500
• $1,500 + $500 = $2,000 for the year 

This yields an APR of 20% because the cost to borrow the money ($2,000) is 20% of the principal ($10,000). 

Example #2 

For a $10,000 one-year loan with: 

• Interest rate = 14%
• Origination fee = 10%
• Total interest for one year = $1,400
• Total origination fee = $1,000 

This would give you an APR of 24%, because the cost beyond borrowing the money ($2,400) equals 24% of the principal ($10,000). 

The loan with the lower interest rate is more expensive because the more significant origination fee causes the APR to increase. 

What is an interest rate? 

An interest rate is the cost of borrowing money, shown as a percentage of the loan amount. 

Interest rate tells you how much a lender will charge you each year just for lending you the money (not including any additional fees). 

Interest rates can vary widely depending on the type of loan, the lender, and the borrower's credit history. In general, higher interest rates can indicate a greater risk for the lender, while lower interest rates can represent a lower risk. 

How to calculate interest rates 

Lenders tend to use their own proprietary formulas to determine interest rates. Oftentimes, there are a few factors that come into play. 

First, the lender will look at the prime rate, which is the lowest rate at which banks lend money to their customers. The federal funds rate, also known as the prime rate, is set by the Federal Reserve. 

The lender may also consider your credit score when calculating the interest rate. A higher credit score can indicate that you're a lower-risk borrower, so you may qualify for a lower interest rate. The loan’s repayment term length may also affect the interest rate. 

There are two common ways to calculate interest: simple interest and compound interest. Here's how each works: 

1. Simple interest formula 

This is the easiest type to calculate and is often used for short-term loans. 

Formula: Interest = Principal × Rate × Time 

• Principal = the amount you borrowed
• Rate = annual interest rate (as a decimal)
• Time = loan term in years 

Example: 

If you borrow $5,000 at a 6% annual interest rate for 3 years: 

• Interest = 5,000 × 0.06 × 3
• Total: $900 

2. Compound interest

This is more common in credit cards, savings accounts, and some loans. Interest is calculated on both the principal and any previously earned interest. 

Formula: A = P(1 + r/n)nt 

• A = total amount after interest
• P = principal
• r = annual interest rate (decimal)
• n = number of times interest is compounded per year
• t = time in years 

To find just the interest: A – P 

Example: Using the figures from our first example, if you borrow $5,000 at a 6% interest rate compounded monthly for 3 years: 

• A = 5,000 × (1 + 0.06/12)12×3 ≈ $5,983.40
• Interest = 5,983.40 - 5,000
• Total: $983.40 

➢ RELATED: Simple Interest vs. Compound Interest

APR vs. interest rate

While both APR and interest rate are used to describe the cost of borrowing, they represent different parts of that cost. The interest rate is the basic charge for borrowing money, expressed as a percentage of the loan amount. It only accounts for the loan's interest (not any additional fees). So, it tells you how much you’ll pay in interest each year, but not the full price. 

The APR includes not only the interest rate but also other costs like loan origination fees, mortgage insurance, or closing costs. That’s why APR is usually higher than the interest rate. Looking at the APR helps you understand the full yearly cost of a loan and makes it easier to compare your options. 

FAQs 

Why is an APR higher than an interest rate? 

An APR is usually higher than an interest rate because it includes the interest, plus any additional fees that come with the loan (expenses that the interest rate alone doesn’t reflect). The APR spreads these extra costs over the life of the loan and expresses them as a yearly percentage. 

This gives you a more complete view of what you’ll pay. Even if two loans have the same interest rate, the one with more fees will have a higher APR, making it the more expensive option overall. 

Can an APR be less than an interest rate? 

Typically, no. An APR will not be less than an interest rate. An APR is almost always higher than the interest rate because it includes extra costs like fees and insurance. 

Should I look at both APRs and interest rates when comparing loans? 

Interest rates and APRs are both important factors to consider when comparing loans. Looking at both the interest rate and the APR will help you get a sense of how much the loan will cost. This can help you find the right loan for your budget and needs. 

Should I get a loan with a lower interest rate or lower APR? 

The right interest rate or APR depends on your particular needs and preferences. In some situations, a lower interest rate may be ideal. Other situations may warrant a lower APR. 

If lower monthly payments are your priority, for example, look for a lower interest rate. But if you prefer to pay less for your loan overall, a lower APR should be on your radar. 

Final thoughts: APR vs. interest rate 

Knowing the difference between an APR vs. interest rate is important for making informed financial decisions. Don’t just focus on the interest rate when comparing loans –– look at the APR to understand the true cost of the loan over time. 

Remember that a lower interest rate may not always be the better deal –– sometimes lenders make up for a low interest rate with a high APR. It’s smart to compare the interest rates and APRs of different lenders and see which offers the best overall cost. Once you've found the loan with the lowest cost, you can consider other factors like repayment terms to find the perfect fit. 

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