APR vs. interest rate explained

Any time you borrow money from a bank, a lender, or an established business, there will be a cost attached to your loan. Two important terms to understand in this context are interest rate and APR. However, interest and APR aren't interchangeable, so understanding the difference between them when you shop for credit could make a significant cost difference over the life of a loan. Whether you're borrowing money to buy a condo or a car — or financing your college education — you'll want to understand the total actual cost.

Key takeaways when comparing interest rate vs. APR include:

• An interest rate is the narrowly defined price you pay your lender when you borrow money — usually quoted as the percentage that, multiplied by the amount of the loan or principal, determines how much the money will cost.

• When determining what interest rate to charge you, a lender will consider your credit history, the size of your down payment, the type of loan, and the loan terms.

• The APR is more inclusive: it starts with the interest rate, but it adds other costs that the lender might charge in the form of origination, transaction, and other fees.

APRs are typically higher than interest rates in mortgages and car loans because they include costs beyond just the interest. However, credit card interest rates and APRs are often identical because there may be no costs beyond the interest.

APRs and interest rates are both percentages used to compare loan options, reflecting your cost of using the money. The primary difference is that the interest rate is just one component of the APR, so unless there are no other costs, the APR will always be higher than the interest rate.

Most credit advertising highlights the interest rate and leaves it up to an astute borrower to hunt for the APR. The differences are most significant in mortgages and car loans, where lenders can add origination fees, transaction costs, application fees, settlement fees, and credit report fees — among many others. You will only know the total amount you’re paying for the loan by identifying the APR.

Interest rate is a percentage applied to most lending or borrowing transactions, regardless of the use of the funds. In essence, interest is the cost of debt incurred by the borrower to use the funds and serves as compensation to the lender for no longer having the funds to invest in something else.

Several factors are considered when lenders determine a borrower's interest rate. Read on for the more important ones.

Your credit score is crucial in determining what interest rates lenders will offer. Its calculation is based on information gathered by credit reporting companies regarding:

• Your credit history

• How much of your existing credit you're using

• How prompt you are in paying cyclical debts — from car loans to light bills

• How you use your credit cards

Your credit score indicates to a lender how reliable you are in repaying a loan. The higher your score, the more reliable you are considered, and the lower the interest rate the lender will offer.

The size of your down payment affects your interest rate. The more money you contribute, the more you are "invested" in your purchase and the lower the lender's perceived risk.

Down payments are particularly important in the case of mortgages. If your down payment is less than 20% of the property's value, you may have to buy private mortgage insurance (PMI) that protects the lender if you default on the loan.

The loan term, or how long you have to pay it back, also affects your interest rate. The shorter the loan term, the lower the interest rate because the lender's money is exposed for a shorter period. However, shorter loan terms result in larger monthly payments.

For example, on an auto loan, you may be offered a lower interest rate for a 48-month loan compared to a 72-month loan. However, since you'd be dividing the loan's principal by 48 instead of 72 monthly payments, the total monthly payment amount might exceed your budget despite the lower interest rate. In the case of a 72-month loan, in addition to a higher interest rate you'd pay interest for an extra two years, increasing the total repayment cost.

Loans are structured with either fixed or adjustable interest rates. Fixed rates stay the same for the life of the loan, which helps with budgeting because payments also remain the same. Also, suppose you can lock in a low interest rate on a loan, and the economy experiences an inflationary period. In that case, you'll benefit from paying the loan back with less-valuable dollars. Alternatively, you could get locked into a higher interest rate and be stuck with it when market rates fall.

Adjustable rates typically start with a fixed period, then increase or decrease depending on market factors. The advantage is that adjustable rates usually start lower than equivalent fixed rates at that time. However, they leave the borrower exposed to interest rate risk each time it adjusts over the life of the loan.

Adjustable rates can be found in the mortgage industry, but they predominate in the credit card industry. The interest rates on credit cards are often linked to the prime rate, a short-term interest rate commonly used in the U.S. banking system. A creditworthy borrower may be offered the prime rate as the interest on a card, whereas a less creditworthy borrower may get prime rate plus two to ten percent. In either case, the interest charged for that period's loan balance goes up or down with the prime rate.

The federal funds rate is the rate commercial banks use to borrow and lend their excess reserves to one another overnight. It is not used directly to set interest rates for consumer lending, but it can indirectly influence short-term interest rates on credit cards and consumer loans.

The Federal Reserve's Federal Open Market Committee (FOMC) sets this target interest rate as part of its monetary policy to guide the behavior of the nation's economy. For example, the FOMC will lower the federal funds rate to encourage consumers to spend or raise it to encourage them to save. The economic impact of the FOMC's monetary policies subsequently influences the broader market conditions that help lenders determine the interest rates they offer.

Your mortgage interest rate is the percentage your lender charges you to borrow the funds to buy a property. Your loan will be paid off once you pay back the loan's original amount or principal, plus any interest charges as they accumulate during the life of the loan.

Depending on the mortgage, the interest rate may be fixed, in which case it remains the same throughout the repayment period. It can also be adjustable, which means the loan may be set up to change interest rates at specific intervals and according to specific calculations.

With a fixed-rate mortgage, the balance you owe will go down as you start paying back the principal. Most fixed-rate mortgages apply amortization to pay the debt in equal monthly installments so your payments are always the same. The portion of the installment applied to interest is high at the start of repayment but declines over time, while the portion applied to the principal does the opposite.

Adjustable-rate mortgages (ARMs) typically have a five-year or seven-year introductory period where the interest rate, which is usually lower than market rates, remains fixed. At the end of the introductory period, market factors drive the rate up or down within a predefined range.

So what does APR mean? APR is your loan's actual interest rate over a year after all extra expenses have been added to the interest rate. In the case of credit cards, these expenses can be $0, so the interest and the APR can be identical. Or, in the case of mortgages, they can include lender fees, mortgage broker fees, points, insurance, closing costs, and anything else you pay to obtain the loan — in which case the APR will be noticeably higher than the interest rate.

The APR calculation follows a seemingly complicated formula, as follows:

Using the formula above:

• Interest = the total interest paid over the life of the loan
• Principal = the loan amount

The formula for APR can be explained in five steps:

• Step 1: Add the loan's fees and total interest paid over the loan's life.

• Step 2: Divide that by the principal or the original loan amount.

• Step 3: Divide the result by the number of days in your loan's term.

• Step 4: Multiply that figure by 365.

• Step 5: Multiply your result by 100 to make it a percentage.

Alternatively, simplify the process by using an APR loan calculator.

APRs vary based on what kind of asset they are financing. Here are some of the more common APRs listed below.

Personal bank loan APRs can be fixed or variable. If fixed, it is guaranteed not to change during the life of the loan. If variable, the rate can change according to the terms determined for the loan. These fixed-amount loans are withdrawn as a lump sum to pay for personal expenditures and, as such, offer no collateral. Payments are typically made in fixed monthly installments. The APR the bank offers can be based on your:

• Credit score

• Debt-to-income ratio

• Annual income

• Loan purpose

As for your mortgage rate vs. APR, mortgage APRs include the mortgage interest rate, as described above, plus any fees and expenses required to obtain the mortgage loan. The vast list of additional costs can include:

• Private mortgage insurance (PMI)

• Discount points

• Prepaid interest

• Closing costs, among others

As a result, the mortgage APR will always be higher than the cited mortgage interest rate. It reflects the actual cost of your loan and should be the measure you use to compare multiple mortgage loan offers.

Like other financing, car loans consist of the interest rate you pay yearly to borrow the money, cited as a percentage. But auto loan interest rates are personalized and reflect, among other factors, your:

• Credit history and score

• Down payment

• Loan duration

So, what is APR for car financing? Again, the APR adds specific fees associated with the loan. These fees are often referred to as "prepaid finance charges," which can include an origination fee that lenders use to cover their loan underwriting costs or to increase their income.

Credit card APRs often vary with the reason the credit is being used. Here are the three most frequently applied APRs:

• The purchase APR is the rate the issuer will apply to purchases you make and don't repay in full by the time your next bill is due.

• The cash advance APR is the cost of borrowing cash from the line of credit available on your card: a higher interest rate, possibly an extra fee, and interest that starts accruing when you take the advance.

• The penalty APR is the predetermined rate as high as 29.99% that your lender will impose on you for missing a payment or going well past your due date.

A mortgage APR includes the lender's cited mortgage interest rate, plus various fees and costs related to obtaining the loan and amortized yearly, as explained in the section "Example: Mortgage Interest Rates."

For example, a 30-year fixed-rate mortgage advertised as a 5.5% interest rate may cost you something above 5.6% once you factor in a 1% origination fee and other relevant fees. That is the figure you’d want to use in comparing lenders' offers.

In fact, since different mortgage lenders will choose to include different fees and costs, the APR can be different between loan offers even if the underlying interest rate is the same.

The APR becomes your best tool to compare multiple fixed-interest mortgage offers. However, it is less effective at capturing the cost of adjustable-rate mortgages (ARMs) because there is no way to predict how the interest rates will change after the initial fixed-interest period.

Let FinanceHQ connect you with an accredited financial advisor who can help you make the right financing decision — or show you how to save money by writing off mortgage interest or refinancing an existing mortgage. An advisor can also determine if consolidating debt is worthwhile under your financial circumstances.