APR vs. interest rate: What’s the difference?

Do you know the difference between the APR and the interest rate? (iStock)

If you’re in the market for a new loan or a credit card, understanding all the technical jargon tossed your way is essential. Knowing specific numbers will make it much easier for you to make a financial decision that works best for your particular circumstances.

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Many people believe that the APR and interest rate are interchangeable, but they’re not. While they are similar, the APR provides a little more information than just looking at the interest rate.

What is an APR?

The APR or Annual Percentage Rate is the total cost of your loan, including fees, represented in a percent. Charges factored into the APR can include mortgage insurance, loan origination fees, closing costs, and points. The APR does not consider any compounding factors.

To calculate an APR, lenders multiply the periodic interest rate by 365 days. Credit cards typically have a fixed APR, while some loans may have a variable APR. If your loan has a variable interest rate, that means it can change any time (depending on your other loan terms).

WHAT APR MEANS ON YOUR CREDIT CARDS AND LOANS

Lenders are not required to include all their fees in the APR, so make sure you ask your lender if they have additional charges.

The APR on a credit card and the APR on a mortgage loan won’t always operate the same way since the balance on your credit card could vary widely from month to month. Additionally, APRs for introductory periods, cash advances, and balance transfers all work a bit differently depending on your lender.

What is an interest rate?

Your interest rate is the cost of the loan over a year, without additional fees factored into the percentage. The interest rate determines your monthly payment.

What are the key differences between and APR and interest rates?

The most significant difference between an APR and the interest rate is that the APR offers a complete picture of how much a loan will cost, while the interest rate provides a shorter-term view.

VISA OR MASTERCARD: WHAT'S THE DIFFERENCE BETWEEN THE CREDIT CARDS?

Consumers can use one or both when comparing potential lenders. Comparing APRs will provide a bigger picture, but an interest rate can give you a quick view of possible monthly payments. The APR does not affect your monthly payments.

The market and your credit score determine your interest rate. Lenders are responsible for determining their APR, which is why they’re different from company to company.

For example, if you get an offer for a $300,000 home loan with a 5 percent interest rate, you’d pay $15,000 in interest over the first year. This amounts to about $1,250 per month. But, if your lender adds closing costs, loan origination fees, mortgage insurance, or other fees to your loan, that number could change. Let’s assume the total charges are $3,500. Your new loan amount is $303,500. When you divide that by the 5 percent interest rate, your new annual cost is $18,210. When you divide that number by your original loan amount ($300,000), your Annual Percentage Yield (APY) is 6.07 percent.

In this example, the difference between your interest rate and your APR is 1.07 percent.

Your monthly payment will stay the same as indicated by the interest rate, but the APR shows you the actual cost of your loan over time.

Why is APR usually higher than your interest rate?

The APR is most often higher than the interest rate because your interest rate only tells you how much the loan will cost, without considering additional fees.

While all these numbers can be confusing, looking at both the interest rate and the APR will help you score a better deal. If you’re comparing two lenders, a lower APR indicates fewer fees, which means a lower cost for you over the life of the loan.

Note: If you plan to pay the loan off faster than the loan terms, the APR won’t be as helpful when comparing offers because the APR assumes payment through the life of the loan.