The APR, or annual percentage rate, is different from the interest rate you’ll pay on a loan when you have upfront loan fees. Lenders are required to supply the APR in the loan estimate to provide you with a rate that accounts for costs associated with the loan.
Here’s a quick read to help you distinguish between APR vs. interest rate and what questions you can ask your lender to get the best deal on a loan.
What is an interest rate?
An interest rate is what you’ll pay to borrow money. It’s a percent of the total loan amount you’ll pay each year to finance the loan. When you make your monthly payment, part of it will include your interest payment on the loan.
How an interest rate works
How the interest rate is calculated depends on the type of loan you get. Most loans, such as auto loans and mortgages, are amortized. It’s not simple, so a great mortgage calculator or amortization table can help.
With an amortized loan, the amount of interest paid is recalculated each month of the loan based on the remaining loan balance. The portion of the payment going to interest is greater in the beginning stages of the loan. Toward the end of the loan term, more of the monthly payment goes toward paying down the principal loan amount.
Example of how an interest rate is calculated
For example, if you have a $400,000 fixed, 30-year mortgage at an interest rate of 6.49%, you’ll see a payment of $2,526 for principal and interest each month. In the first month, $362 goes toward the principal and $2,163 goes toward interest.
In the second month, the interest is calculated the same way, but the amounts going to interest and principal change with the balance reduction from the previous month’s principal payment.
At the end of the loan, more of the monthly payment goes to the principal.
Why your interest rate matters
The interest rate is a crucial part of your loan due to how drastically it can affect your finances. You’ll pay significantly more over the life of your loan when your interest rate is higher. You also qualify for a smaller loan when the interest rate is higher.
See also: 15-year fixed mortgage
What is APR and how is it calculated?
APR is how much you’ll pay for your loan including interest and fees. It’s figured at an annual rate.
A lender is required by the Truth in Lending Act (TILA) to disclose the APR. It’s designed to give you straightforward information about the true cost of the loan when accounting for fees.
Example of calculating APR
It’s helpful to know how APR is calculated. To calculate the APR, you’ll add all the fees to the dollar amount charged in interest each year, then divide by the original loan amount.
As a formula over the entire loan term, it looks like this:
APR = (Interest charges + fees) loan amount / Loan term X 365 X 100
It’s easier to understand with an example and to simplify by using calculations for each year.
Let’s say you borrow $20,000 at a 7% interest rate with $200 in fees and a four-year repayment term.
Step one: Calculate the dollar amount of interest charged each year
$20,000 (principal loan amount) X 7% interest rate (0.07) = $1,400 per year in interest charges.
Step two: Add the fees charged for the loan each year
If your loan term is four years, you’ll first divide your total fees by four to get the fees charged for the year.
$200 (total loan fees) / 4 years (loan term) = $50 in fees per year
Add the annual fees and annual interest charges together.
$1,400 (annual interest charges) + $50 (annual loan fees) = $1,450
Step three: Divide by the original loan amount
$1,450 (total interest charges and fees) / $20,000 (principal loan amount) = 0.0725
Step four: Multiply by one hundred to change the decimal to a percentage
0.0725 X 100 = 7.25%
The APR is 7.25% for a four-year $20,000 loan that charges $200 in fees and a 7% interest rate.
Comparing APR and interest rate in mortgages
APR vs. interest rate makes a large difference for mortgages. This is because mortgages have many fees that, when accounted for, change how much you’ll pay.
The APR may include mortgage costs such as:
- Interest
- Discount points
- Origination fees
- Mortgage insurance
- Some closing costs
It does not include:
- Taxes
- Homeowners insurance
- HOA fees
- Home inspection
- Appraisal
- Credit report fees
- Title insurance
“The APR is important because it’s going to tell you how much this loan is going to cost you in upfront fees,” says Alexa DePaolo, branch manager for Prosperity Mortgage Group powered by Edge Home Finance Corporation. “So when you’re seeing an interest rate at 6% and an APR at 6.2%, that’s a good indication that this is not a terribly expensive loan. There’s minimal difference between those two.”
“But if I’m seeing an interest rate at 6% and my APR is 7%, that means that this is a really high-cost loan. That’s going to be a very expensive loan when it comes to fees,” she says.
Tip:
When you review offers, find out what the APR includes. Some banks offer interest rate discounts for existing customers, so the published APR may reflect that. Find out if you’d need to set up an account or meet other requirements to get a lower rate.
How APR affects credit cards and loans
Unlike mortgages, credit card APRs are usually the same as the interest rate. However, you might see different APRs that apply to different types of transactions.
For example, the regular APR on a credit card might be 25.99%, but the cash advance APR is 29.99%.
You might also see an introductory 0% APR on purchases or balance transfers. For these offers, be sure you know the terms and conditions. Most cards require balance transfers to be initiated in the first 60 to 90 days (depending on the card). After the introductory period, the APR will return to the regular APR.
Tips for evaluating APR and interest rates when choosing a loan
Here’s how to evaluate APR and interest rates when you compare offers from different lenders.
Compare the right numbers on your loan estimate
First, you’ll want to only look at the numbers that lenders have control over. This boils down to two questions to ask your lender:
- What is your interest rate?
- What are your lender-specific loan costs?
The other costs when you’re getting a mortgage, such as title insurance, homeowners insurance, and property taxes, aren’t determined by the lender.
DePaolo says it’s possible that if a lender knows you’re shopping around, it may exclude these fees or give a lowball estimate to make its offer look better.
“Comparing a bottom line to a bottom line is not the best way to compare if you're getting the best cost rate,” DePaolo says.
Provide property-specific information on your loan estimate
DePaolo says to make sure the lender has all the property information so it can give you an accurate estimate of the interest rate.
“Interest rates are based on not only credit scores, but they can change based on ZIP codes, loan amounts, loan-to-value ratios, and property types,” she says.
Watch your interest rate and lender credits on a no-closing-cost loan
DePaolo also advises buyers to pay attention to their interest rate and lender credits if they’re looking at no-closing-cost loans. No-closing-cost loans let you spend less upfront, typically because closing costs are rolled into the loan amount. If you purchase lender credits, the lender will usually give you money upfront to pay closing costs in exchange for a higher interest rate over the entire loan term. Both of these can reduce the amount you’ll need upfront, but it’ll cost more over the life of the loan.
Note:
Closing costs typically range from 2% to 5% of the home’s price. For a $200,000 home, this would be about $4,000 to $10,000.
APR vs. interest rate FAQ
How do I find the APR on a loan offer?
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Is APR more important than interest rate?
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Can APR change after agreeing to a loan?
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