Published in: Personal Loans | Nov. 26, 2019
APR vs. Interest Rate: What's the Difference?
By: Dana George
An interest rate isn't the same as an APR. Here's how they differ.
Every loan has an interest rate and an annual percentage rate (APR). But what's the difference? What does APR have to do with your interest rate and how much you'll need to pay?
Here's the answer you've been looking for.
What is interest rate?
A loan's interest rate represents the amount you'll pay for borrowing money over a period of time. Nothing else. No origination fees, closing costs, documentation fees, or other charges related to your loan are included.
It's like ordering a hamburger only to find that the bun, ketchup, mustard, onions, and pickles aren't included in the stated price. The total cost of the burger is a different number altogether.
In the case of loans, the total costs are found in the annual percentage rate (APR). We'll talk about that in a moment.
How banks determine your interest rate
Lenders can set their own interest rates and fees within legal limits. And different borrowers get different rates.
The interest rates advertised online are reserved for customers with the highest credit scores. If that's not you, the rate you're offered will be based on a number of factors:
- Credit score.
- Loan amount.
- Debt-to-income ratio.
- Down payment amount.
- Length of the loan. Generally, the shorter the repayment term, the lower the rate.
- Where you live. The interest rate in some regions of the country is higher than in others.
- The type of credit you applied for. For example, a credit card normally carries a higher interest rate than a mortgage or auto loan.
- The fees you pay for the loan.
Those fees are also important in calculating your APR. Let's take a look at how that works.
What is APR?
A loan's annual percentage rate (APR) includes all those pesky fees you'll pay for borrowing money. Unlike a stripped-down, bare-bones interest rate, APR reveals the full price of the loan expressed as a percentage. It shows the full cost of taking out a loan, instead of just interest.
The fees attached to your loan (and figured into your APR) depend on the type of loan you've applied for. Here's a sampling of the fees you can expect to see:
- Application fee: The fee some lenders charge to apply for a loan.
- Origination fee: An upfront fee designed to compensate the lender for putting a loan together.
- Underwriting fee: A fee charged for the underwriter who reviews your application and decides whether to grant credit.
- Document fee: Lenders often bake this fee into the loan to cover the effort it takes to draw up the documents you'll sign.
- Dealer prep: Auto dealers normally slip this fee into their APR, saying they've earned it for preparing a vehicle for sale.
- Processing fee: A general term for any extra fees a lender hopes you'll pay. Many are negotiable.
Why banks publish annual percentage rates
At the turn of the 20th century, banks could charge whatever interest rate they wanted. Without regulations in place, they routinely earned from 10%–500% annually on mortgages and private loans. Americans in need of a home loan had to work with mortgage lenders who acted more like loan sharks than bankers.
In 1968, Congress passed the Truth in Lending Act (TILA). Lenders now have to give consumers a complete picture of how much a loan would cost, including fees. Thus was born the modern APR.
The history of lending is a surprisingly fascinating topic. If you want to find out more, I highly recommend Loan Sharks: The Birth of Predatory Lending from the Brookings Institution.
Which is more important, interest rate or APR?
Both interest rate and APR tell you important things about a loan. But comparing the APR of a loan to its interest rate is very helpful:
- You can compare apples to apples. All lenders must follow the same rules when calculating APR (with a couple of variations we'll touch on in a moment). You have a better sense of the true cost of a loan with APR and you can compare it to other loans.
- You know how much a loan will cost at a glance. Without a stated APR, it's a matter of working through individual fees and adding them to the interest rate. That's time-consuming.
- You can see how much you'll pay in fees. Compare the APR to the interest rate. The closer the two numbers, the fewer fees are built in.
Both the interest rate and APR tell you how much you'll pay for a loan. But the APR tells you a lot more, so it's generally more useful. However, you'll want to compare them both. Let's take a look at an example to see why.
How interest rates determine your monthly payment
To save money, compare the rates of several lenders before signing on the dotted line. Here's how it works:
Let's say you want to borrow $30,000 for a new car. The interest rate at Bank A is 6.75%. If you take out a five-year loan, your monthly payment will be $590.50. You investigate and find that Bank B offers an interest rate of 6%, giving you a monthly payment of $579.98.
Your monthly payment is based on the interest rate on your promissory note, not the APR. The slightly higher rate at Bank A makes their monthly payment $10.52 more each month than Bank B's monthly payment. It doesn't sound like much, but over the life of the loan that difference amounts to $631.20 -- enough to buy a set of tires or have your oil changed 10 times.
Keep in mind, however, that you'll need to look at the APR to compare the total cost of the loans, which includes more than the monthly payment.
Understanding fixed- and variable-rate loans
There are two types of interest rates: fixed and variable.
A fixed interest rate never changes. No matter how many times the Federal Reserve changes the interest rate over the life of your loan, a fixed interest rate loan will never change. It's predictable and easy to budget for.
Variable interest rates are tied to an index rate -- if that rate changes, so does the loan's interest rate. They can fluctuate in a way that lowers your payment, but they can also move in the other direction.
A lower upfront interest rate may attract you to a variable rate loan, but it's important to remember that the rate is likely to change. Ask your lender what your maximum rate may be and how much your monthly payment will be at that rate.
You might see a loan described as "fixed-interest rate" or "variable APR." Because a loan's interest rate is included in the APR, they're both accurate.
Credit cards have multiple APRs
A single credit card can carry several types of APRs. To understand potential interest costs, it's important to know the difference.
- Purchase APR: The rate you're charged if you don't pay your credit card balance in full each month.
- Introductory APR: The temporary low rate sometimes offered on purchases or balance transfers. Once the introductory period is over, the APR jumps.
- Penalty APR: The interest rate your credit card issuer can legally bump up to if you spend beyond your credit limit or make a late payment.
How to get the best interest rates and APRs
Now that you understand the difference between interest rate and APR, let's talk a little about how to find the best options for your loans:
- Do your rate shopping in a short window of time. Hard credit checks can lower your credit rating, but multiple inquiries count as a single inquiry if they're close enough together. The time allowed ranges from 14–45 days.
- Ask a potential lender to explain all the fees included in their APR. Some can be negotiated.
- The Consumer Financial Protection Bureau (CFPB) investigates complaints about financial services like loans, credit cards, and debt collection. If you believe a financial institution has violated TILA or committed a fraudulent act, you can file a complaint with CFPB.
Don't be shy. Ask lenders about the fees included in their APR and let them know you're happy to find another lender if those fees are too high. It's your money, and you have the right to keep as much of it as possible.
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