When you apply for a loan it’s critical to know the interest rate and the APR. Although you might not distinguish between these two terms, they are different — and not knowing the difference could result in your monthly payments being higher than you expected.
Educating yourself about interest rates is the best way to ensure you save the most money. Keep reading to find answers to questions like, “What is an APR?” and “What is the difference between interest rate and APR?” — and make sure you’re fully educated when you’re trying to get a loan.
Interest Rate Explained
So what is an interest rate? When you borrow money, you’ll be charged interest in addition to the principal. The interest rate is expressed as a percent of the total loan amount and your lender will add it to the principal to calculate the monthly payments you’ll need to make to pay off the loan by the end of its term.
A daily interest formula calculates the amount of interest that accrues on your loan each month. To arrive at this number, multiply your loan balance by the number of days since your last payment, and then multiply that number by your interest rate.
What does APR stand for, what does APR mean, and how does APR work? APR is short for annual percentage rate and it refers to your interest rate for an entire year instead of on a monthly basis. Your APR consists of not only your interest rate but other charges that might include document preparation, underwriting, loan processing and application fees. Because of those added fees, a loan’s APR is typically slightly higher than the advertised interest rate.
Here’s an example of how to calculate an APR: If you take out a loan for $100,000 with a 5 percent interest rate, your yearly interest would equal $5,000. To find the APR, assume fees will run you $3,000. Add those fees to the mortgage amount, which equals $103,000 — and you’ll be paying $5,150 in interest at 5 percent. To find the APR, divide the $5,150 by the original loan amount of $100,000, which equals an APR of 5.15 percent.
APR vs. Interest Rate
To better understand the terms, examine the similarities and differences between an interest rate and an APR. Once you learn what they are, you’ll be able to sort out what you’ll really be paying in interest, monthly and yearly.
- Both vary from lender to lender.
- Both can be used to compare loans.
- Both are expressed as percentages.
- An APR includes fees but an interest rate does not.
- An interest rate is typically lower than an APR.
- An interest rate shows the current cost of the amount borrowed but the APR represents the total cost over the course of the loan.
Know the Rate Terms to Avoid Costs
The Federal Truth in Lending Act requires all lenders to clearly display the terms of the loan, including the interest rate and APR. Borrowers who don’t know the difference between APR and interest rate might take on higher payments than they can afford. And that could translate into a repossessed car or a foreclosed home.
APR and Credit Cards
Credit cards carry revolving debt and their interest is often compounded, which an APR doesn’t factor in. To compare credit cards and get the best deal, look for the annual percentage yield, which reflects the total amount of interest you’ll pay on an account. The APY is based on the interest rate and the compounding frequency for a 365-day period.
When you’re ready to borrow money, do your homework. Read all mortgage, loan and credit card contracts to see how much you’ll be paying over the life of the loan — and ask questions if you don’t understand a term. Make sure you have all the facts you need to make an informed decision.