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Infographic: APR vs Interest Rate Explained
APR vs Interest Rate Explained for Beginners
Two loans with the same interest rate could end up costing you very different amounts. APR is what exposes this difference.
I passed the CFP® exam at 16 and have helped millions improve their finances over the last 8 years.
I’ll show you exactly how interest rate and APR work, and how they impact mortgages, credit cards, and student loans.
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What Is an Interest Rate?
When you borrow money, you repay what you borrowed plus extra money, called interest. The interest rate decides how much extra you have to pay back, and is expressed as a percentage.
For the same loan amount and repayment period, a lower interest rate means you pay less in interest.
But the interest rate alone doesn’t tell the whole story, since it doesn’t tell you what you had to pay to get that loan in the first place.
A lender might offer a lower rate but charge you a fee upfront. How do you account for that?
That’s where APR becomes useful.
What Does APR Mean?
APR stands for Annual Percentage Rate. It starts with your interest rate, but also accounts for any fees you pay to get the loan.
Together, this is expressed as a single yearly percentage, which gives you a simple way to compare loan offers from multiple providers.
Imagine two mortgage lenders offer you a 6.5% interest rate. One charges almost nothing to set up the loan, while the other charges several thousand dollars.
The interest rates are identical, but since you’re paying more overall for the second loan, it would have a higher APR.
While studying for the CFP® exam, I learned that APR works best when you compare the same kind of loan over similar repayment periods.
Otherwise, differences between the loans themselves can make the APR comparison less useful.
Remember, APR does not replace your interest rate. If your mortgage rate is 6.5%, the lender still uses that rate to calculate interest on your balance.
APR gives you a broader picture of the cost of borrowing by accounting for the additional fees.
APR helps you compare loan offers, but remember, it doesn’t include every cost you might pay.
What Mortgage APR Includes and Excludes
Let’s look at how it works for mortgages.
Mortgage APR includes many of the fees tied directly to getting the loan.
- Origination fee is what the lender charges to create and process your mortgage
- Discount points are money you pay upfront to get a lower interest rate
- Mortgage broker fee pays a broker who helps arrange the loan between you and a lender
But APR still leaves out some costs you might have to pay.
For example, property taxes that go to your local government, homeowners insurance premiums, and some closing costs paid to outside companies for things like an appraisal or title work.
Those expenses still increase your cost, even though they don’t increase the APR.
But APR can look different depending on the kind of loan.
Annual Percentage Rate APR vs Interest Rate – Other Loans
With some student loans, an origination fee is deducted from the amount given out to you.
That means you receive less money than the loan’s stated principal, but you still have to pay back the full amount.
This fee increases your cost of borrowing, and makes the APR higher than the stated interest rate.
With credit cards, the gap between interest rate and APR for purchases usually disappears.
The APR is essentially the annual interest rate you pay when you carry a balance. Annual fees, late fees, balance-transfer fees, etc. are normally listed separately and don’t raise the APR.
Auto loans are somewhere in between.
If the lender charges an origination fee to set up the loan, the APR can be a little higher than the stated interest rate. Otherwise, the two can be very close.
But how do you get the lowest APR possible? By raising your credit score!
Check this out to find out exactly how your credit score is calculated and how to increase it, so you can save thousands of dollars on your loans: Credit Scores Explained for Beginners: A Complete Guide
