What is the Difference Between Interest Rate and APR?
Each time you borrow money, words like “interest rate” and “APR” will follow you all the way. These two terms might seem similar, but they aren’t. We’re here to make those tricky banking words easy for you. We’ll explain everything about interest rates and APR, find out how they differ, and help you make smart money decisions.
- The interest rate is the cost of borrowing the principal loan amount set by your lender.
- The annual percentage rate (APR) is an annual cost of your loan that consists of both interest and any associated fees.
- Interest rates are determined by various factors, including your credit score, the lender, inflation, and the market conditions.
- When evaluating loan offers, compare the annual percentage rate to assess the real cost of borrowing.
What Is an Interest Rate?
An interest rate is the cost of borrowing money or the return on investment expressed as a percentage of the principal. It is a critical financial concept that is crucial in various economic activities. When you take out a loan or use a credit card, the interest rate represents the percentage of the loan amount you need to pay back in addition to the original sum borrowed.
Here’s an example. Suppose that you borrow $100,000 for 60 months with an interest rate of 12%. Over the loan life, you’ll pay $33,466.69 in interest on top of what you borrowed.
An interest rate you get depends on the federal funds rate, inflation, the state of the economy, and how risky it seems for the lender to give money to you.
There are two kinds of interest rates – nominal and real. The nominal rate is simply a percentage a lender charges you. The real rate goes further as it takes inflation into account. Thus, it gives an accurate picture of the purchasing power value of the interest paid on a loan.
How Are Interest Rates Calculated?
The interest rate is affected by different factors. Here are the essential ones:
- Guideline rates: Central banks like the Federal Reserve in the US set the federal funds rate. This rate is charged by banks when they borrow from each other overnight. It affects the general rates environment.
- Credit risk: Lenders look at how likely borrowers can repay the money. Those with a higher risk of not paying back may be charged a higher interest rate.
- Inflation: Inflation makes money worth less over time. Lenders look at predicted inflation rates when they set interest rates. It helps them keep the actual worth of their returns.
- Market conditions: Supply and demand also influence interest rates. If more people apply for loans, the interest rate might go up, and vice versa. Factors like unemployment rate and economic growth also matter.
- Monetary policy: RBI can lower interest rates by increasing the money supply.
- Government policies: Government policies and regulations can impact the interest rate. For instance, central banks may adjust rates to stimulate or cool down economic activity.
What Is an APR?
The annual percentage rate (APR) is a parameter we use to see how much a loan costs in a year. It includes the interest rate and any extra fees applied to the loan. This way, it reflects more accurate information about the loan’s price.
By knowing the APR, we can compare loans more effectively and see which one is cheaper or more expensive. APR is like a helper for smart money choices. It keeps things clear and helps us choose the best credit products.
How Is APR Calculated?
Loan APR is calculated based on the four following components:
- Interest rate: Your interest rate is determined based on your creditworthiness, the lender’s policy, and current economic conditions.
- Extra costs: Besides an interest rate, lenders can also charge origination fees, closing costs, application and administration fees, transaction fees, money transfer fees, and other extra costs. They are added to your interest rate for a fuller view of your loan costs.
- Repayment period: The loan duration affects the APR and the total amount of interest paid. Long-term loans tend to carry a higher APR and come with more overpayment over the loan life.
- Loan amount: Your principal amount is used as a basis for calculating the APR since it’s applied to the amount you borrow.
APR = ((Interest + Fees / Loan amount) / Number of days of the repayment period)) x 365 x 100
Keep in mind that APR doesn’t take compounding interest into account.
How to Compare Interest Rate Vs. APR: Main Differences
The APR and interest rate are often misunderstood. An interest rate is what it costs to borrow money without considering any extra fees. It’s a percentage of the amount you obtain.
An APR tells a broader story. Besides the interest rate, it includes costs like origination fees, discount points, transaction and transfer fees, administrative fees, closing costs, and other charges. The APR represents the actual yearly cost of your loan.
Therefore, it’s better to consider the APR before taking a personal loan or any other loan product to make wise money choices. By doing this, you can accurately compare multiple loan offers and avoid misleading advertising.
What to Pay Attention to When Choosing the Loan?
Interest rates and APRs are not the only factors that can dramatically affect your borrowing experience. Here are a few more things to consider:
- Compare loan offers: Pre-qualify from several loan providers and check out their terms. This will help you better understand your options.
- Consider fee impact: Some options with no extra fees may come with higher APRs, so you need to calculate your actual loan cost properly and choose the most beneficial option.
- Choose the APR type: Lenders may offer either fixed or variable APRs. While fixed rates are more predictable and stay the same within the entire loan life, they are also initially higher than variable ones.
- Ask about prepayment penalties: If you aim to pay your loan beforehand, it’s important to choose a loan that doesn’t involve any fines for early repayment.
- Assess your financial situation: Look closely at your financial status and repayment capabilities. Make sure a loan fits your budget and aligns with your money goals.
- Improve your credit score: The better your FICO rating, the lower the APR you can get.
- Talk to lenders: Speak with lenders and ask them to explain any confusing terms or aspects regarding your loan. This will help you better understand your loan terms and make an intelligent choice.
The Bottom Line On Interest Rate Vs. APR
Knowing the difference between interest rates and APR is essential to make intelligent money decisions. Interest rates show how much it costs to borrow money, while an APR gives us a more comprehensive view by reflecting extra charges and fees.
With a clear understanding of interest rates and APR, you can feel more certain about money matters. Being responsible when borrowing money can help you make the right decisions to reach your money goals in the long run.
