This post was written by Cristian Ferrier, and it originally appeared on Your Money Geek. It has been republished with permission.
APR vs. Interest Rate: What’s the difference? Is it important to know? How do lenders calculate both? Which one should I use? These are all great questions!
I have good news! This post aims to educate you on Interest Rates and APR, their differences, and how they are calculated.
Interest rate is a general term in loans and lines of credit, and understanding how it works is a relatively simple task. But what about APR?
APR is another prevalent term in financing, yet many people don’t understand its meaning, how it differs from the interest rate, and its impact on borrowing money.
Understanding the APR of a loan or line of credit is a must, as it gives you an overall picture of how much such a loan will cost you in the long run.
With that brief introduction, let’s get to it.
APR vs. Interest Rate
The nominal interest rate, or advertised rate, refers to the percentage you must pay for a specific period to borrow money from a lender. The interest rate is represented as a percentage, and it can be either fixed or variable. While the interest rate can be set for any period, it is usually expressed as an annual rate.
For example, you borrow $3,000 with an interest rate of 5% over 12 months. At the end of the 12 months, you would end up paying $150 in interest, bringing your total to $3,150 ($3,000 principal + $150 interest).
Many factors can affect the interest rate you receive from a lender, including but not limited to the overall economy, financial markets, debt-to-income ratio, credit score, and the amount put towards the downpayment. Your debt-to-income ratio and credit score play an essential factor in determining what is known as your creditworthiness.
Interest rates can vary widely based on the type of credit or loan you are trying to obtain and those factors discussed above. They can range from 0% (usually advertised for some vehicles, appliances, and other items as a means to attract customers), all the way to 30%+ for personal loans to those with poor creditworthiness.
Knowing the interest rate for a loan is crucial. Not only to decide whether to take a new loan but to make a plan to pay existing debt, using strategies such as the Debt Snowball and Debt Avalanche.
Variable vs. Fixed Interest Rate
Interest rates can be either fixed or variable.
A fixed interest rate will never change, regardless of whether external factors that generally influence interest rates change, like financial markets. Thus, with a fixed interest rate, your interest rate remains the same for the loan duration.
A variable interest rate, on the other hand, can vary during your loan lifetime. That is because variable interest rates are tied to an index rate, and if such index rate changes, so does your interest rate.
The Annual Percentage Rate, or APR, includes the interest rate of the loan and all other costs involved in it, such as fees, closing costs, discount points, etc.
Same as the interest rate, the APR is also expressed as a percentage, and in the majority of cases, it should be the same or higher than the interest rate.
Let’s use the same example we used above for interest rates:
You are borrowing $3,000 with an interest rate of 5% for 12 months. To process the loan, the lender is charging you a $30 processing fee. At the end of the 12 months, you would end up paying a total of $3,180 ($3,000 principal + $150 interest + $30 fee). In this case, the APR is 6%.
The APR gives you a whole picture of how much it costs you to borrow money. However, it is essential to consider both the interest rate and the APR when comparing loans.
The fees involved in your loan depend on what type of loan you are applying for. Here are some of the most common ones:
- Application fee: some lenders charge a fee just for the loan application, and you are responsible for it whether you are qualified or denied.
- Origination fee: a fee designed to compensate the lender for the work needed to put the loan together.
- Processing fee: a general term for any extra fees, many of which are negotiable.
- Document fee: a fee designed to cover the effort needed to draft the loan documents.
- Underwriting fee: a fee charged to cover the underwriter costs, the person that reviews the loan application and makes the final decision on whether to grant credit.
- Dealer prep: an additional fee usually added by dealerships when taking out a car loan.
To further expand on it, credit cards can have multiple APRs, and it is essential to be aware of them and understand their difference:
- Introductory APR: the rate given for a temporary amount of time, usually to attract consumers. After the initial introductory APR is over, the regular purchase APR jumps in.
- Purchase APR: the regular rate you are charged for balance carried month after month.
- Penalty APR: the rate your credit card company can legally bump you to if you exceed your credit limit or default on your payments.
A Little APR History
At the beginning of the 20th century, bankers and creditors could charge whatever interest rate they wanted, as there were no regulations in place. That often meant averages of 10% for mortgages and up to 500% annual interest rates for private loans. In many cases, lenders use lower interest rates as bait, but high fees were hidden and not disclosed to consumers upfront.
The Truth in Lending Act (TILA) was enacted as federal law in 1968 to protect consumers when dealing with lenders.
One of the most significant changes brought up by the TILA was the information lenders needed to disclose to consumers, such as the annual percentage rate (APR), terms of the loan, and the borrower’s total costs. This information must be presented to the borrower upfront before signing any document, and in some cases, on periodic billing statements.
How Lenders Calculate the Interest Rate
Lenders calculate your interest rate using your data. Every lender has its formula to calculate the interest rate, and so you will most likely get five different rates from five lenders.
While you don’t have much control over the actual interest rate given to you, there are things you can do to increase your creditworthiness and, thus, improve the interest rate lenders provide you. These include your credit score and your debt-to-income ratio.
- Credit score: a number ranging from 300 – 850 that tells lenders, at a glance, how well you handle credit. Many factors go into calculating your credit scores, such as payment history, credit utilization, length of credit history, new credit, and credit mix.
- Debt-to-income ratio (DTI): this is the percentage of your gross monthly income that’s tied into debt. That shows lenders your ability to manage monthly payments for any new debt you plan to acquire. A 35% or less DTI is considered good, with some cases, such as a home loan, bringing that number around 43%.
- Government-backed loan: an additional way to reduce your interest rate is by using government-backed loans such as VA, FHA, or USDA loans. These are insured by the federal government and typically carry a lower interest rate than conventional loans.
How Lenders Calculate the APR
Things are a little different when it comes to APR, and unfortunately, you have less control over it, as your lender controls all of the fees that, along with your interest rate, make up your APR.
However, one of the things you can do to lower your APR, at least when it comes to taking out a home loan, is to put at least a 20% downpayment. That will allow you to avoid Private Mortgage Insurance (PMI) and, in turn, lower your APR.
Additionally, you can lower your APR by simply negotiating the lender fees or buying discount points in home loans.
- Discount points: discount points allow you to buy “points” in exchange for a lower interest rate. You are trading off a higher upfront cost (paying for the points) for a reduced monthly payment, saving you money over time.
APR vs. Interest Rate – Which One Should You Use?
So now you understand what the interest rate and APR are. But, which one should you go by when comparing loans? Unfortunately, the answer is, it depends.
While the APR gives you an overall picture of how much a particular loan will cost you, a lower APR doesn’t necessarily mean the loan is better for you.
For this reason, it is always important to consider both the interest rate and APR of the loan. As part of this equation, knowing or estimating whether you will repay the loan sooner or not makes a difference.
In some cases, such as with a mortgage, a loan with a higher APR and lower fees can be cheaper if you keep the loan for a shorter term, meaning that you either pay off the loan sooner or end up refinancing or selling the loaned asset.
As a general rule:
- If you plan to keep the loan for the duration of the loan term, then simply comparing APRs from different lenders can tell you which loan will cost you less over time.
- If you plan to pay off the loan sooner, you can’t simply go by the interest rate or APR numbers when comparing loans. A loan with a higher interest rate and APR, but lower fees, can cost you less if you keep it for a shorter term.
This scenario happens because, initially on a mortgage, you are mostly paying fees, and thus the interest rate doesn’t play a significant factor until later years into the loan.
What if you have the money to pay for something upfront? Should you take out a loan for it or pay it in full? Understanding what is known as opportunity cost can answer that question.
Knowing the interest rate and APR of a loan is essential when comparing multiple loans or simply deciding if taking a loan at all is the right choice.
However, it’s not as simple as choosing the lower interest rate or APR, as we have learned. It is also essential to understand the loan term and whether you plan on keeping it for that long or not.
Having the complete picture of a loan you plan to take can allow you to make the right financial decisions or whether to take a loan or not, pay an existing loan sooner or invest the money instead.
And remember, there are things you can do to improve your creditworthiness, and thus the interest rate you receive from lenders. Additionally, you can always negotiate lender fees, and in turn, lower your APR.