When comparing loans, interest rates are only part of the package. One of the most important factors to consider is the annual percentage rate (APR). A loan with an interest rate too good to be true could have a bloated APR lurking beneath the surface.
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If you are shopping for the right mortgage or choosing between credit card companies, you need to understand the difference between the two because you could save thousands in the long run.
To help you find the best deal, here is a guide to interest rates and APR:
Understanding interest rate
The interest rate is a percent of the amount you borrowed — a fee that the financial institution charges for letting you use its funds. Because it is a percentage of a total amount, the more you borrow, the higher you pay in interest. For example, if a credit card company had an interest rate of 20% and you owed them $100, you would also owe them $20 in interest. If you owed $200, your interest payment would amount to $40. This seems simple enough, but interest rates can be deceiving, as they leave out a number of bank and finance fees. For the most part, you will get a better picture of how much your loan will cost by looking at the annual percentage rate.
APR is essentially an interest rate that has been calculated for the entire year. Just like your monthly interest rate, the APR boils down to money you are paying to take out the loan. While the monthly interest rate primarily applies to the principal, APR also factors in any up-front fees when calculating your required payment. Because the APR takes costs such as participation fees and closing fees into account, it is generally a better measure for comparing loans. The APR is a comprehensive finance charge, calculated as a yearly percentage of your original loan amount.
APR on credit cards
Credit cards have notoriously high interest rates, partly because credit cards usually offer loans with an APR compounded daily. This means that every day, your fee is calculated and added to the amount you owe. Then the next day, your interest is recalculated — this time with the principal and the added interest from before. Compounded loans mean your interest payments are growing exponentially. Even a small balance on your credit card can balloon over time.
Interest rate and APR on all loans
Figuring out the difference between interest rate and APR is also essential when comparing car leases, mortgages and student loans. Luckily, while some terms may change according to the type of loan, the APR within any given sector is legally regulated. It is unlikely that one company will offer an APR of 10% while another tries to get away with 50%. Nonetheless, on large-scale loans, careful comparison can translate to saving thousands of dollars. The Federal Truth in Lending Act requires lenders to disclose your APR, so you can better compare each loan. This legislation also ensures that you are informed of any finance charges you are expected to pay and the total amount you will have paid if everything goes exactly as scheduled. Due to how interest rates and APR work, this total amount can increase or decrease depending on how proactive you are with your payments. There are also plenty of online tools to help you figure out your APR on a loan, such as this calculator on bankrate.com. While all this research can be exhausting, it’s always a good idea to invest time before investing your money.