APR vs. Interest Rate
When you shop around for loans, you’ll find that lenders advertise APRs and interest rates. Since APRs give you an idea of their fees in addition to their interest rate, lenders are required to show you both figures.
By 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?
An annual percentage rate, or APR, represents the cost of funds for the term of a loan. Put simply, APR gives you a broader measure of the cost of borrowing money.
How APRs are calculated
APRs are calculated by adding any fees, 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.
Your loan’s APR will usually be higher than the interest rate. Interest rates can be confusing. If a loan with a lower interest rate has a lot of fees then it can actually cost more than a loan with a higher interest rate but no fees.
For example, let’s say your interest rate is 15% for a $10,000 loan with a one-year term, and the loan has an origination fee of 5%. The total interest for one year will be $1,500, and the origination fee will be $500, which equals $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).
A $10,000 one-year loan with an interest rate of 14% and an origination fee of 10% per year would cost $1400 for interest, plus $1,000 for the fee. This would give you an APR of 24%, because the cost beyond to borrow the money ($2,400) equals 24% of the principal ($10,000). This loan costs more than the loan with the lower interest rate, because the higher origination fee causes the APR to be higher.
What is an interest rate?
An interest rate refers to the amount of interest that is charged on a loan as a percentage. This does not account for any additional fees. While the interest rate is important to know, it doesn’t show you the total cost of borrowing.
How interest rates are calculated
Lenders use their own proprietary formulas to determine interest rates. Many of them will consider different factors related to your finances when doing so, along with the federal funds rate set by the Federal Reserve.
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.
What’s the difference between APRs and interest rates?
An interest rate is what you pay a lender to borrow money, expressed as a percentage. 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.
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 any fees. A lower APR means you’ll pay less for a loan overall.
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.