APR vs. Interest Rate
When you shop around for loans, you’ll find that lenders advertise annual percentage rates (APRs) and interest rates. Since APRs, along with interest rates, give you an idea of fees, lenders are required to show you both figures.
Understanding the importance of both APRs and interest rates, you can choose the right loans for your unique situation. Let’s take a closer look at how an APR compares to an interest rate.
What is an APR?
Annual percentage rate (APR) represents the cost of funds for the term of a loan. Put simply, APR gives you a broader measure of the cost of taking out a loan.
The APR includes the interest rate charged on the loan and other fees that may be associated with the loan. APR is expressed as a percentage and can be used to compare different loans. For example, a loan with a lower APR will typically be less expensive than a loan with a higher APR.
How to calculate APRs
APRs are calculated by adding other fees charged by the lender, such as a loan origination fee, to the amount of your interest. The APR, or annual percentage rate, is the standard way to compare how much loans cost. It lets you compare the cost of loan products on an “apples-to-apples” basis.
For example, if your $10,000 one-year loan has an:
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 and APR of 20% because the cost to borrow the money ($2,000) is 20% of the principal($10,000).
In another instance, if you had a $10,000 one-year loan with an:
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?
Interest is essentially the cost of borrowing money. When you take out a loan, the interest rate is the percentage of the loan that you will be required to pay back in addition to the principal.
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.
The interest rate does not account for any additional fees, and while the interest rate is important, it doesn't show you the total cost of borrowing.
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, or 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. Finally, the loan’s repayment term length may also affect the interest rate.
How are interest rates and APRs determined?
There are several factors that play a role in your interest rates and APRs when you apply for loans, including:
- Credit history: Your credit history shows lenders how responsible of a borrower you are. A higher credit score can lead to better rates.
- Employment type and income: Whether you work a traditional job, are self-employed, or don’t work at all may affect your rates. Your income will be considered as well.
- Loan type: There are many different types of loans that come with different levels of risks. A collateral loan, for example, is less risky than an unsecured installment loan and may come with a lower rate.
- Loan size: Loan size refers to how much money you’re asking for. Since lending a large amount of money is riskier than a small amount, you might get a higher rate if you want a $50,000 loan instead of a $5,000 loan.
Difference between APRs and interest rate
An interest rate is what you pay a lender to on an ongoing basis while you repay your loan, expressed as a yearly percentage of the amount you borrowed. A lower interest rate usually leads to lower monthly payments. APR, on the other hand, is the total cost to borrow money, expressed as a yearly percentage of the amount you borrowed.
Compared to the interest rate alone, the APR gives a more complete picture of the cost of a loan. It includes the interest rate plus other fees charged by the lender. A lower APR means you’ll pay less for a loan overall.
Why an APR is higher than an interest rate
Lenders use both APRs and interest rates to calculate the cost of borrowing money, but they're not the same. An APR includes not only the interest rate but also other fees that may be required to obtain the loan. As a result, an APR is generally higher than an interest rate. This can be confusing because you might see two loans that have the same interest rate but different APRs. The loan with the higher APR will actually cost you more in interest and fees over time.
Can an APR be less than an interest rate?
In most cases, the APR will be higher than the interest rate because it includes additional costs. For example, if there is a balance transfer fee, that will be included in the APR. The same is true for any other fees and charges associated with the loan.
Should I look at both APRs and interest rates when comparing loans?
Interest rates and APRs are two crucial factors to consider when comparing loans. So, it’s important to look at both the interest rate and APR to get a true sense of how much the loan will cost. This can help you find the right loan for your budget and needs.
What APR and interest rate are right for me?
In general, you should consider aiming for the lowest APR and interest rate possible. However, there may be some instances where a higher interest rate is worth paying to get a lower APR. For example, if you plan on paying off your loan quickly, a higher interest rate may not impact your overall costs as much.
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
Now that you understand the difference between an APR and an interest rate and how lenders calculate them, you can begin to compare loans and make your decision.
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. When looking for the right loan, 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.