What is the Difference Between APR and Interest Rate?
Have you wondered whether interest rate and APR are the same thing? As the two concepts are quite similar and widely used in the context of lines of credit and mortgages, it may not be so clear what they refer to. Before you decide on a certain loan, it’s crucial you understand the difference between the terms so you can determine the final cost.
Keep reading to find out the difference between APR and interest rate, how to calculate either of them, and important tips for comparing the two.
Interest Rate vs. APR: Understanding the Terms
To actually understand what is the difference between interest rate and APR, we need to start with some basic definitions.
An interest rate refers to an amount charged by a lender when you take a loan or money for a mortgage. If you are a borrower, this amount is your cost of debt, and it is shown as a percentage of a loan principle.
The annual percentage rate (APR) includes the interest rate and any other fees that your lender will charge. Depending on the lender, these may also include origination or closing fees. APR shows the final yearly cost of a loan instead of some part of the sum.
Here’s the APR vs. interest rate comparison in more detail.
Interest Rate | Annual Percentage Rate (APR) |
Refers only to the cost of borrowing the loan principal | Includes interest rate and any additional fees that apply to a loan (origination, etc.) |
Doesn’t include additional charges linked to a loan | Is the most accurate representation of the final cost |
Is usually lower compared to the APR | Is normally higher than nominal interest rates |
Affected by the federal funds rate | Controlled by a lender for the most part |
The most important thing to remember is that interest rates are only a part of the lenders’ charges, while the APR is the total of what you need to pay.
How Is APR Calculated?
To continue our interest rate vs. APR mortgage review, let’s discuss how APR is calculated. If you decide to calculate an APR, you should use the following information:
- Exact loan term;
- Original loan amount (referred to as the principal);
- Total interest charges;
- Any additional costs and fees incurred;
- The amount you have to pay monthly.
Once you have all this data on hand, you can proceed to the calculation. While it may seem intimidating, the process is quite easy if you enter the right information.
The formula for determining PR looks like this:
APR = (((Relevant fee + Interest charges) ÷ Loan amount) ÷ Days in a loan x 365) x 100
To illustrate the calculation process, let’s use an example in which you take a $10,000 personal loan with a 9% interest rate, a 5% origination fee, and a 2-year term for repayment. Here’s how the calculation process will go:
APR = ((($500 + $900) ÷ $10,000) ÷ 730 x 365) x 100
As a result, you’ll get an APR of 7% for the loan. If you don’t want to calculate the sum manually, you can always use an online calculator or add the formula to Microsoft Excel.
How Is Interest Rate Calculated?
Next in our APR versus interest rate is the interest rate calculation.
As opposed to the APR, you cannot simply calculate the interest rate using a specific formula, as it’s the amount of money that a lender charges you for the loan. Lenders can prioritize a variety of factors by which they decide what interest rate they will give you, making the calculation basically impossible.
As you don’t have any control over a lender’s decisions, the best strategy is to simply look for interest rates that you deem acceptable and calculate your APR later.
Interest Rate vs. Annual Percentage Rate: Tips to Compare
When applying for a loan, you should be able to confidently compare the APR and interest rate. This way, you won’t have to go through the trouble of figuring out why your final payment is higher than you expected.
Use the following tips when choosing a loan:
- Make sure you compare different options before deciding on a lender.
When looking for a loan, you should pay attention not only to interest rates but also to additional fees. In some cases, a lender may offer a higher interest rate but demand no upfront fees, making the situation favorable for you.
You should carefully compare the offers available to you, as this will determine how much you’ll have to pay for the loan.
- Pay attention to the APR to get the most accurate understanding of the loan cost.
Interest rates are important, but the APR will give you a more realistic look at the cost of your future loan. APR includes both interest rates and fees, so you can be sure that there won’t be hidden costs that you didn’t take into consideration.
- Make sure you understand the difference between ARM and fixed mortgage.
Another thing to pay attention to is the difference between the interest rate for an adjustable-rate mortgage (ARM) and the one for a fixed mortgage. If you go for an ARM, you should take into account that the announced rates will go up once the introductory period is over. If you go for a mortgage with a fixed rate, this won’t be the case.
The same goes for calculating APR on your ARM. During the initial period, the APR will be determined using interest rates relevant at that moment, and it can increase significantly when interest rates go up.
