Interest rates and annual percentage rates are two of the most critical factors to review when you’re shopping around for a loan. But what do these terms really mean, and how can understanding their differences help you make a smarter financial decision?
Interest rates are expressed as a percentage of the principal that a lender charges you for borrowing the money. The APR describes the annual cost of a loan to you and includes the interest rate as well as any additional costs, such as origination fees or transaction fees. The APR, therefore, is typically higher than the interest rate.
Since you’ll want to know both the interest rate and the APR of a loan, let’s take a look at the similarities and differences between these terms.
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Financial institutions, including banks, lenders and credit card companies, charge you interest as the cost of borrowing money. The interest rate is the percentage of the principal (also known as the amount loaned). Think of the interest rate as the monthly cost of borrowing money. If your credit background is solid, you’ll likely qualify for a lower interest rate since you’re at a lower risk of default. However, banks charge higher interest rates to borrowers they deem high risk. Here’s how interest rates work on debt:
The bank applies the interest to the total outstanding balance. For example, if your unpaid loan amount is $500 and the interest rate is 8%, your balance will be $540 with interest applied.
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It’s important to know whether a lender charges you simple or compounded interest on a loan since that can significantly increase your monthly payment. These are the differences:
- Simple interest: This is a set percentage paid on the initial principal. For example, if you borrowed $2,000 and paid it back two years later at 15% annual interest, you ended up paying $600 in interest in addition to the principal amount.
- Compound interest: This is when lenders charge interest on top of interest. Each year, the previous year’s interest is added to the principal. So, for the previous example, since the interest would tack on to the principal each year, you would have ended up owing a total amount of $2,645.
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APR is a broader calculation of the cost of the loan and takes into account the interest rate and any other fees and costs. If you are taking out a mortgage, for example, the APR describes the interest rate, any discount points, mortgage broker fees, closing costs and any other additional charges.
Calculating the APR can give you a complete picture of the total cost of the loan over its entire lifespan.
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Interest rates and APR are both useful tools to help you calculate the total cost of a loan. They’re both expressed as percentages and describe the costs of borrowing the principal loan amount. Here are the key differences and how they affect you:
When you’re making a monthly payment, the interest you pay is based on the interest rate calculated on your principal.
When To Consider Interest: When you’re concerned with the amount of your monthly payment, the interest rate will help you determine the more immediate cost to you.
The APR is more helpful as a tool to help you determine the true costs of the loan, such as a mortgage loan. Since mortgage loans come with many additional fees, it can be useful to compare the APR of different loans, so you’ll see which one will be more cost-effective in the long run.
When To Consider APR: When you’re purchasing a home that you plan to stay in for the duration of the loan period, look for the loan with the lowest APR. A higher APR with fewer upfront fees will make more sense if you’re only planning to spend a few years in the house.
APRs and interest rates are both essential to an accurate assessment of a loan or credit card. Since interest rates add to the cost of paying the total amount, it’s best to look for an offer with the lowest possible interest rate. When the APR and the interest rate are the same, that means you don’t have to pay any additional fees. Those fees are how you end up with a higher APR.
Keep in mind that when it comes to credit cards, the APR and the interest rate are the same. The APR is just the amount of interest you’re paying on your credit card.
When you’re considering a long-term loan, such as a mortgage, it may be best to review the APR of various loans so you can see the true costs over the entire lifetime of the loan. You’ll be able to make a more informed financial decision knowing the actual cost of borrowing.
This model for a $100,000 30-year mortgage illustrates how using the APR and interest rate can help you compare the total costs of a loan.
|30-Year Mortgage Comparison|
|Loan A||Loan B|
|Total Costs Over 30 Years||$171,853.20||$164,653.20|
Monthly Payments = L[c(1 + c)n]/[(1 + c)n – 1], where L stands for “loan,” C stands for “per payment interest” and N is the “payment number.”
Points are optional fees you can pay on the front end to lower your ongoing interest rate. Each point is 1% of your balance. In this scenario, Loan A comes with more costs but a lower interest rate. In Loan B, the interest rate is higher, but the fees are much lower. Loan B would be the better choice since you will save more money over the lifetime of the loan. As you can see, if you stayed in the house for the entire 30 years, you would save yourself just over $7,000.
Now that you know the difference between interest rates and APR and how they tie into the costs of borrowing, you can make smarter financial decisions. Both terms are useful and important in any loan review. Depending on what type of loan you’re considering, you can understand the more immediate cost to you as well as the long-term cost.
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