Interest rates, annual percentage rates, origination fees, and more. These words can trigger feelings of confusion and uncertainty for any first-time borrower. Maybe you feel completely lost when your lender starts to explain the terms of your loan offer, or maybe you catch your eyes glazing over at the first hint of financial-speak.
But when you’re looking to buy a home, refinance your student loans, or take out a personal loan, you’ll need to know the distinction between an interest rate and APR -- two terms you’ll encounter often while shopping for a loan.
Even though they both influence how much you’ll pay, comparing only the interest rate doesn’t show you the whole picture of the cost of your loan. Not accounting for a loan’s APR can throw off your budget and, in the worst-case scenarios, sabotage your financial situation too. That is why it’s in your best interest to understand these two terms before you apply for a loan.
The interest rate tells you how much you’ll pay for borrowing money over a period of time. This number, expressed as a percentage, is the price a lender charges you for taking out a loan. However, a loan’s interest rate doesn’t take into account the other fees you’ll pay. Combining a loan’s principal amount with its interest rate only gives you its “subtotal,” so to speak.
Think of it like buying a concert ticket to see your favorite artist: As you compare different seating options, you’ll only see the base price of the ticket -- the amount before the ticketing company adds its own charges. You don’t see the total cost of the ticket, which includes taxes and processing fees, until the checkout page.
In addition to showing you how much you’re paying for the loan itself, lenders will use the interest rate to calculate your loan’s monthly payments.
As you’re shopping for loans, keep in mind that lenders set their own rates and fees, so the numbers will be different from lender to lender. And if that wasn’t confusing enough, interest rates also depend on the borrower’s financial situation.
To calculate interest rate, some things a lender considers include:
Your credit score
The total amount you’re borrowing
Your debt-to-income ratio
Your down payment
The loan term
So how do you compare different loans with different interest rates, different lifespans, and different fees? You look at the loan’s APR.
The annual percentage rate (APR) of a loan represents its total cost.
It includes additional charges like origination, documentation, and processing fees that a lender might charge in addition to the principal and interest. If we were to take the concert ticket example from earlier, the APR would be like the “grand total” of the ticket, including taxes and other fees.
Like interest rates, APR is expressed as a percentage. A loan’s APR will almost always be higher than its interest rate to account for the extra fees. Because of this, you can also use the difference between these two percentages to get a sense of a loan’s additional costs.
Despite its huge impact on the lending process we use today, financial institutions didn’t offer annual percentage rates until 1968, when Congress passed the Truth in Lending Act (TILA). The establishment of TILA required all lenders to disclose the total cost of their loans, along with all the additional fees. That was how the modern-day APR came to exist. The Truth in Lending Act makes it easier for borrowers to shop for the loan that’s right for their budget. All lenders must follow the same rules when setting their APR, so it’s now easier than ever to compare different loans from different lenders.
Keep in mind, though, that some fees may not be factored into a loan’s APR. Lenders may choose not to include costs like appraisal and inspection fees into their calculations. In the case of credit cards, you’ll find that many of their fees aren’t factored in either (more on that below).
So, when you’re comparing different loans, make sure to ask your lender what costs are included in the APR and if there are any that aren’t.
A loan’s interest rate and APR are ways for loan shoppers to easily compare the terms and affordability of different loans. Although the interest rate plays a large role in your loan’s monthly payments and is a good measure of how much you’ll pay for the loan itself, the APR is an estimate of the bigger picture -- how much you’ll pay in total over the life of the loan.
Additionally, all loans come with a lot of moving parts to consider: the interest rate, the term, and all the associated fees. Comparing these points between different loan options can be a headache for any borrower. But because the Truth in Lending Act regulates annual percentage rates, you can use the APR to compare different loans with ease. Say, for example, you have two similar loans with the same monthly payment but different APRs. You’ll pay more on the loan with the higher APR, because the total cost of the loan is higher. Generally speaking, a lower APR means less total fees for you to pay.
Another difference you’ll want to keep in mind:
Installment loans like personal loans, mortgages, and student loans use “interest rate” and “APR” to make the distinction between the cost of the loan itself and the cost of the loan plus fees. On the other hand, for revolving loans like credit cards, the terms are used interchangeably.
Interest rates and APR tell you the costs of taking out a loan, and they’re both important factors to consider before accepting any offer. The APR, though, can reveal more information because it considers a loan’s additional costs as well as its interest rate. Any loan offer you see from Personify will show you the estimated APR. If you’re in the market, take a look. You’ll find attractive personal loan options that you may not find at other places.
And with a new awareness of how interest rates and APR work together, you’ll be better equipped to choose the loan terms that best fits your budget.