What is an interest rate?
An interest rate is an annual percentage of the principal amount borrowed that a borrower pays a lender. You can expect to pay an interest rate on installment loans—a set amount of money you borrow and then pay back over a set amount of time—such as mortgages, auto loans, student loans, and personal loans. You can also expect to pay an interest rate on unpaid balances on revolving lines of credit (like credit cards), which allow someone to repeatedly borrow up to a set limit as long as they make minimum regular payments.
While the interest rate is important to consider, it doesn’t factor in fees associated with the loan. That means judging a loan’s affordability solely on the interest rate may not give you the full picture.
What is an APR?
An APR, or annual percentage rate, is the interest rate you pay to borrow money, plus certain fees or finance charges that may be related to your loan. The APR, which is also expressed as a percentage, provides a more complete picture of your annual borrowing costs than the interest rate alone.
Let’s say you’re considering a $10,000 personal loan with an annual interest rate of 6%, a 5-year repayment term, and a 5% origination fee, which is deducted from the principal before the funds are disbursed to you (but not every loan will have an origination fee and when they do, it might not be 5%). That means you’ll receive $9,500 for the loan and pay back $10,000 with a 6% interest rate over a 5-year period. Though your annual interest rate is 6%, the APR for this loan is 8.155% because APR factors in the origination fee.
Interest rate vs. APR: Similarities and differences
Below are important factors to keep in mind when shopping for a new loan or revolving line of credit.
Both rates can be fixed or variable
With a variable-rate loan, the interest rate can fluctuate over time—affecting your monthly payment and your total loan costs. Since APR factors in a loan’s interest rate, it’s possible for the APR to also fluctuate. Be aware that lenders may offer a lower-than-average introductory rate on variable-rate loans, but that rate will likely increase.
Neither tells the whole story about what you’ll pay to borrow money over time
Interest compounds. That means you not only owe interest on the original amount you borrowed (the principal) but also on the accumulated interest that’s already been accrued. The frequency at which interest compounds can greatly change how much you owe over the life of the loan. That’s not reflected in the interest rate. And while the APR provides a standardized annual rate for comparison, it doesn’t explicitly state the total dollar amount of interest that you will pay over the loan’s life. Because your loan may be compounded daily, monthly, quarterly, biannually, or annually, it’s important to understand how often your loan’s interest compounds and how it could affect your total loan costs.
Interest rates don’t include fees
Interest rates are just one part of a loan’s total costs. Depending on the loan type, lenders can also charge:
- application fees
- origination fees
- transaction fees
- closing costs
- points
- dealer fees
- private mortgage insurance
Many of these fees are factored into APR depending on the loan type and lending rules.
The APR must be disclosed when you sign the loan
To protect consumers and enable comparison shopping, federal law requires lenders to provide a clear disclosure of the APR and other loan costs before you are contractually committed to the loan. This way, borrowers can easily compare options and better understand the overall cost of borrowing. If the interest rate goes up, that must be communicated too.
APR, interest rate, and you
When evaluating a loan offer, here’s what to consider about the interest rate and APR.
- For many standard credit card purchases, the APR is typically the same as the stated interest rate because there are generally no upfront fees for making a purchase. Exceptions could include cash-advance or balance-transfer APRs, as well as promotional APRs.
- Comparing APRs may only be helpful if both loans have similar interest rate structures and repayment schedules. For instance, if one loan’s interest rate is fixed and another is variable, comparing first-year APRs doesn’t give you enough information because you don’t know what the second year’s interest rate will be on the variable-rate loan. As for differing repayment schedules, take the personal loan example from earlier—borrowing $10,000 with a 6% interest rate and a $500 origination fee. If instead of a 5-year repayment term you have a 10-year repayment term, that 8.155% APR drops to 7.145%. That’s because the $500 origination fee’s impact is spread across 10 years instead of 5, lowering the APR.