APR vs. Interest Rate: Understanding the Difference can Save You Money

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.

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).

Variable vs. Fixed Interest Rate

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.

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