When you’re shopping around for a loan, you may be tempted to compare offers based on the interest rate quoted by the lender. But the interest rate is only a slice of the full picture. A more comprehensive metric you can use is the APR. In this article, we’ll look at the differences between APR vs. interest rate and how knowing the difference can help you find better loan deals.
What is an interest rate?
The interest rate is the amount of interest a borrower will pay over one year. For example, if you borrowed $10,000 with a 10 percent interest rate and had to pay the whole thing back after one year, then you’d owe $11,000 (the original $10,000 plus $1,000 in interest).
Many loans use fixed interest rates when calculating the payment amount (such as a conventional 30-year mortgage). However, other loans are designed to have interest rates that can fluctuate over time, such as adjustable-rate mortgages or ARMs. Note that the interest rate used by credit cards is also subject to change.
What is an APR?
The annual percentage rate, or APR, is how much the borrower is truly paying to finance their loan. Although it often gets misinterpreted as the interest rate, they are not the same thing. APR takes into consideration the total amount of interest expense you’ll pay plus any other applicable expenses, including:
- Fees (such as origination fees or some closing costs)
- Private mortgage insurance (PMI)
- Mortgage points (also called prepaid interest)
When broadening the picture to include these additional expenses, it becomes more transparent to the borrower that the “true” cost of the loan is much higher than just the interest alone. So, the advertised APR will be higher than the interest rate.
The Federal Truth in Lending Act requires lenders in all covered loans to disclose the APR before an agreement is signed. This is useful to the borrower because it gives them a good starting point for similar types of loans. However, you still need to be careful and understand that not all APRs are necessarily the same. For example, the rules used to calculate APR are slightly different for open-ended credit (i.e. a credit card or line of credit) than they are for closed-end credit (e.g. a fixed-amount personal loan or standard purchase-price mortgage).
How to calculate APR and interest rate
When you apply for a loan, the interest rate you’ll be offered will be based on several criteria. The main factor will be the Federal Reserve’s interest rate and how this has affected what the industry calls the “prime rate”. This is the starting point used by lenders to calculate the interest rates for all other loans.
Other factors that can alter your interest rate will include things like the type of loan being applied for and your credit score. Borrowers with a higher credit score may qualify for a better interest rate.
Once the interest rate is known, APR can be estimated as follows:
- Take the total interest paid plus any other fees charged by the lender to the borrower as a condition of giving the loan (e.g. an origination fee, or points).
- Divide this value by the total principal (amount being borrowed).
- Divide the result by the total number of days in the loan.
- Multiply the result by 365 to adjust this figure relative to one year.
- Multiply this result by 100, to obtain the percentage.
There are some variations, based on the specific type of loan, in the types of fees which must be included in the APR and the exact method lenders are required to use for calculation of the APR however, so this method of calculating APR may not yield the exact rate reflected by the lender.
The bottom line
If you’re thinking about getting a loan, don’t compare offers based on the interest rate alone. Remember to use APR since it will include the interest expense plus fees. Although APR won’t be the same for all loans, it will give you a much better starting point for deciding which offer is right for you.