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Understanding the subtle differences between various credit cards and loan products is difficult enough on its own. But it gets even more confusing when you start throwing around technical terms. Two of these terms: interest rates and APR, cause some of the most confusion.
These terms are often used interchangeably, but they aren’t the same. It’s important to understand the difference because if you don’t, it could make it difficult for you to understand the true cost of a credit card, mortgage, or personal loan.
In this guide:
- What is the difference between Interest Rates and APR?
- What does the interest rate measure?
- What does the annual percentage rate (APR) measure?
- How can I convert the interest rate to the APR?
- Frequently Asked Questions
What is the Difference Between Interest Rates and APR?
The interest rate on a credit card or loan is the annual cost you’ll pay for borrowing money — expressed as a percentage of the principal amount you borrow. Although it’s an annual rate, interest is usually divided into monthly payments, so you only pay a 1/12 of your annual interest rate each month.
On some products, such most mortgages, the interest rate is fixed and will not change (although adjustable-rate mortgages do exist). On other products, such as most credit cards, the interest rate is variable, so it can increase or decline as the federal government adjusts the prime borrowing rate.
Annual percentage rates (APR) include all the costs associated with administering a loan or line of credit, including various fees and interest. For that reason, a loan’s APR will almost always be higher than the interest rate and a more accurate predictor of how much your loan or credit card balance will cost. Although an APR may include some fixed fees, it’s still expressed as a percentage of your loan principal.
Remember that both APRs and interest rates are annual, but they can easily be broken down into a monthly or daily rate.
In order to calculate the expected daily cost of a loan’s APR or interest rate, take your total balance and multiply it by your rate. Next, divide that number by 365. To determine a monthly cost, divide it by 12 instead. Of course, this figure is only accurate for your current outstanding balance. If you pay off a large portion of your debt tomorrow, then the daily cost of your APR will decline, even though your rate stays the same.
What Does the Interest Rate Measure?
The interest rate is the amount charged to a borrower for the principal loan amount or credit card balance. This is expressed as a percentage of the total principal. It’s kind of like a rental charge, indicating the cost of borrowing money.
The riskier a borrower is, the higher their interest rate will be. Borrowers that have a long credit history with a record of on-time payments can qualify for a lower interest rate, while borrowers with a limited or damaged credit history and low credit scores will receive a higher interest rate.
There are two different rate types: fixed and variable. A fixed rate stays the same throughout the life of the loan while a variable rate changes.
If a lender wants to change the fixed rate on a loan, they are required to notify the borrower in writing. However, variable rates can change without the borrower knowing.
What Does the Annual Percentage Rate (APR) Measure?
The APR includes the interest rate but it also includes any additional fees and charges imposed by your lender. Because it’s more comprehensive, the APR is generally more useful than the interest rate when comparing the costs of various financial products.
And just like with interest rates, the APR will either be fixed-rate or variable. Variable APRs will change periodically while fixed rates stay the same over the life of the loan.
How Can I Convert the Interest Rate to the APR?
Understanding the APR can be helpful in understanding the full cost of taking out a loan. However, it’s important to keep in mind that the APR does not account for the effects of compounding interest on credit cards.
Compounding means that you pay interest not only on the money you borrowed in the first place but also on the unpaid interest that was added to that amount. So even after you’ve converted the interest rate to the APR, you still don’t know the full cost of your revolving credit card debt.
Let’s say you took out a $200,000, 30-year fixed-rate mortgage at a 6% interest rate. What is the true cost of that loan? For the sake of simplicity, let’s set aside the downpayment and any additional payment amount that goes toward paying down your mortgage principal.
6% of 200,000 is $12,000 — or $1,000 a month in interest. However, your monthly mortgage payment would likely be higher to include loan origination fees, mortgage insurance, broker fees, or other expenses tacked onto the loan — let’s say $1,100 (again, not including the amount that pays down the principle). To convert this amount into your APR, you’ll need to follow this process:
- Multiply your monthly interest-and-fee-payment by the total number of periods you’ll pay on the loan each year ($1,100 x 12).
- Divide that total by the present value of the loan ($13,200 / $200,000).
- Multiply that amount by 100 to get your final APR (0.066 x 100 = 6.6% APR)
As you can see, this is .6% higher than the actual mortgage rate and is a better indicator of the true cost of the home loan.
Frequently Asked Questions
When you’re trying to find the best rates, understanding the difference between APR vs interest rates can get confusing. Here are four questions you may still be wondering about:
Why is the APR Higher Than the Interest Rate?
Because the APR is a more comprehensive view of what you’ll pay for that loan. If you’re taking out a mortgage, the APR may include the interest as well as closing costs, insurance, fees, and more. So, the APR is almost always higher than the interest rate. However, be aware that the fees included in your APR may vary, and not all fees may be included, so you should carefully examine the fine print of your loan agreement to determine the total cost of borrowing.
Should I Pay Attention to the APR or the Interest Rate?
Both are useful and will help you understand the true cost of your loan. Fortunately, the Federal Truth in Lending Act mandated that every consumer credit card agreement include information about both the APR and the interest rate. It also requires that all lenders follow the same guidelines for coming up with an accurate APR. This ensures that consumers can quickly compare the true costs of different credit cards — as long as they understand the difference between the two terms.
Your interest rate is the percentage you’ll pay for taking out the loan. The APR measures the interest rate plus any other fees you’ll pay on the loan.
If you plan to repay the loan balance in a short amount of time, a higher interest rate might not cost as much as a loan with a lower rate and a lot of upfront fees. But if you plan to carry the balance for the full loan term, the product with the lower APR is cheapest.
What is a Good APR?
This depends on a variety of factors including your creditworthiness, the current prime rates, and the type of loan or card you’re applying for. For credit cards, the national average credit card APR last year was about 15.32%. So to achieve a good APR, you’ll want to find a credit card that is lower than that.
When it comes to loans, credit union personal loans tend to offer better APRs than banks or online lenders. But the lowest APRs are given to the most creditworthy borrowers.
Does a 0% APR Mean There’s No Interest?
Many credit cards offer a 0% intro APR for a fixed amount of time. This means you’ll pay no interest until that promotion expires. Depending on the card, the 0% APR will usually last anywhere from six to 15 months.
Bottom Line: Understanding the Difference Between Interest Rate and APR
When you understand the difference between APR and interest rate, it’s easier to compare financial products. For instance, two mortgage loans could have the same interest rate, but one could have a higher APR. This means you’d pay the same amount in interest each month but spend more on additional fees and expenses.
Fortunately, when it comes to credit cards, most companies now advertise the APR as opposed to the interest rate. This makes it easier to compare credit cards. As a general rule, a lower APR indicates lower overall costs for the cardholder.
Author: Jamie Johnson