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? In other words, what’s the story behind APR vs. interest rate?
What is an interest rate?
To understand APR vs. interest rate, it’s important to understand a simple 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 fee, closing costs, documentation fee, or other charges related to your loan are included. Say you’re shopping for a personal loan, and the advertised rate is 4.99%. The first question you need to ask yourself is whether the rate on that personal loan includes any other fees.
Looking at interest rates can feel 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.
That’s why it’s important to look at the interest rate vs. APR. When it comes to a loan, the total cost is found in the annual percentage rate.
How banks determine your interest rate
Researching a lender’s interest charges is an important first step in comparing APR vs. interest rate. Lenders set their own interest rates and fees within legal limits. And because different borrowers get different rates, your interest rate might be different from a lender’s advertised rate.
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
- Upfront fees (generally paid to keep the rate low)
- Down payment amount
- Length of the loan (generally, shorter terms have lower rates)
- The type of credit you apply for
That last point is especially important. For example, a credit card normally carries a higher interest rate. Mortgage and auto loan interest rates tend to be lower.
How interest rates determine your monthly payment
The interest rate plays a large part in determining your monthly payment. Here’s how it works:
Let’s say you want to borrow $30,000 for a new car loan. 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 loan’s life, that difference amounts to $631.20 — enough to buy a set of tires or have your oil changed 10 times.
To save money, compare the rates of several lenders before signing on the dotted line. However, keep in mind that you’ll need to look at the APR vs. interest rate to compare the total cost of the loans, which includes more than the monthly payment.
What is APR?
The value of knowing the difference between the APR vs. interest rate is recognizing the “real” cost of a loan. 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, with all the bells and whistles you’ll pay for on top of regular 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 in your APR:
- 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. The stated interest rate does not include this fee, while APR does.
- 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. It’s yet another cost that becomes part of interest rate vs. APR.
- Dealer prep: Auto dealers normally slip this fee into their APR, saying they’ve earned the extra money for preparing a vehicle for sale.
- Processing fee: A general term for any extra fees a lender hopes you’ll pay. Many are negotiable.
APR vs. interest rate applies to all types of loans. Unless a lender specifically indicates that a rate is the APR, you must ask what the APR will be.
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 between 10% and 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. APR vs. interest rate was certainly not part of any upfront disclosures.
In 1968, Congress passed the Truth in Lending Act (TILA), and part of that act helped spell out the differences between APR vs. interest rate. Lenders now have to give consumers a complete picture of how much a loan would cost, including fees.
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.
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 between different credit card APRs.
- 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 up.
- 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.
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. Unfortunately, they can also go up and increase your monthly payment.
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. APR vs. interest rate applies to variable as well as fixed-rate loans. 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.” That’s because a loan’s interest rate is included in the APR and can be either fixed or variable.
In the battle of APR vs. interest rate, which is more important?
Both interest rate and APR tell you important things about a loan. Comparing the APR of a loan to its interest rate is very helpful for several reasons.
- It allows you to compare apples to apples. All lenders must follow the same rules when calculating APR (with a couple of variations — we’ll touch on that topic 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 vs. interest rate. The closer the two numbers are, the fewer fees are built in.
APR vs. interest rate bottom line: Both the interest rate and APR tell you about the fees you’ll pay for a loan. But the APR includes all lender fees, so it’s generally more useful. However, you’ll want to compare them both. For example, if you’re interested in knowing your monthly payment, you’ll need to look at the interest rate — not your loan’s APR. That’s because many of the fees included in the APR are paid up-front, not monthly.
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 to 45 days.
- Remind a potential lender that you understand the difference between APR vs. interest rate, and ask them to spell out all fees included in their APR.
- 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 — including trying to mislead consumers about APR vs. interest rate — you can file a complaint with CFPB.
It’s important to note that APR can also benefit you. Let’s say you open a certificate of deposit (CD). APR represents the amount the bank will pay in interest on that financial instrument. The same principle applies when you open a money market account (MMA).
Don’t be shy. Let lenders know that you understand APR vs. interest rate and ask about the fees they include. It’s your money, and you have the right to keep as much of it as possible.
View more information: https://www.fool.com/the-ascent/personal-finance/apr-vs-interest-rate/