Credible takeaways
- An interest rate tells you how much it costs to borrow money on an annual basis, excluding upfront fees.
- APR shows you the cost of borrowing, including upfront fees, expressed as a yearly percentage of the amount borrowed.
- Compare loans using APR, because it gives you the best look at the total cost for each loan, upfront fees included.
When you’re trying to find the best personal loan, rates matter. But how do you know if you should be looking at the APR or the interest rate? And which one matters more?
The interest rate tells you how much it will cost to borrow money with a particular loan, but the APR gives you a fuller picture: not only the interest you’ll pay, but upfront fees, too, making it a crucial number for comparison.
Learn the specifics of APRs and interest rates so you can confidently compare personal loans.
What is an interest rate?
When you borrow, the lender expects you to repay the original amount, called the principal. But it also charges interest, which is the cost of borrowing the money. The interest rate is expressed as a percentage of the amount borrowed on an annual basis.
For instance, suppose you borrow $100 at a 10% annual interest rate, and repay the entire amount in one lump sum at the end of one year. You’d’ll repay $110, which is the amount you borrowed plus an extra $10 in interest (which is 10% multiplied by the $100 loan amount).
However, calculating interest isn’t usually as simple as multiplying the interest rate by the amount you borrow. That’s because instead of making one single annual payment, most loans are paid off monthly. And with each payment, the amount you owe goes down, which means the interest you pay also decreases.
There are two main types of interest rates: fixed interest rates and variable interest rates.
Check Out: Best Personal Loan Rates
Fixed interest rate
A fixed interest rate doesn’t change. If the interest rate is 7% and fixed, it’ll be 7% at the beginning of the loan and 7% at the end. Typically, with a fixed-rate loan, your payment will stay the same each month for the length of the loan.
Fixed interest rates are common with personal loans, including bad-credit loans and other kinds of loans. This also makes them appealing options for debt consolidation purposes.
Variable interest rate
A variable interest rate can change during the loan repayment period. These types of loans may have a low introductory rate for a set amount of time before the rate increases.
Variable interest rates are often tied to a benchmark or index, plus an additional percentage; when that benchmark changes, your interest rate may change, too. One common benchmark is the prime rate. If your variable interest rate is “prime plus 1%,” for example, and the prime rate goes from 5% to 6%, then your interest rate would change from 6% to 7%.
Credit cards usually have variable interest rates, as do a few personal loans. Personal lines of credit also often have variable interest rates.
See Also: Personal Loan vs. Personal Line of Credit
How is the interest rate used on a personal loan?
On a personal loan, the interest rate is used to determine how much your payments will be. Once the lender determines your interest rate, it uses a process called amortization to calculate a monthly payment that will pay off both the interest and principal, in full, by the end of the loan’s term.
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What is APR?
APR stands for annual percentage rate, and it can be a little different from the interest rate. The APR on a loan indicates the total cost of the loan, including the interest rate as well as upfront fees like any origination or administrative fees. So, if there are no upfront fees, the interest rate and APR should be the same.
Like the interest rate, APR is expressed as a percentage. It’s useful when comparing personal loan lenders, because it lets you see how overall costs stack up. Otherwise, you’re not comparing apples to apples.
Fortunately, most lenders express loan costs in terms of APR, so there’s little work needed on your end to calculate it. But if a lender doesn’t, you can use an APR calculator. Simply enter the loan amount, upfront fees, interest rate, and the loan’s term, and the calculator will calculate the loan’s APR.
APR vs. interest rate
To illustrate the difference between APR and interest rate, let’s say you have a personal loan of $5,000. It has a fixed interest rate of 10%, a loan origination fee of 5%, and a repayment period of three years.
While the interest rate is 10%, the APR on this loan would actually be 13.57% (which we figured out by using an APR calculator). This is because of the upfront loan origination fee, which would be $250 in this case.
How rates are calculated
Lenders determine your interest rate and APR based on their perceived level of risk in lending to you. If lenders see you as a high-risk borrower, they’ll likely charge a higher interest rate to protect themselves. Lenders use a few key factors to determine interest rates:
- The loan amount: How much you intend to borrow. Most personal loans offer loan amounts from $600 to $100,000 or more, in some cases.
- Your credit score: Your score is indicative of your credit history, and lenders use it to gauge how likely you are to repay the loan on time. Most lenders prefer borrowers with FICO scores of 670 and above.
- The repayment term: Terms often range from 1 to 7 years, and have a big impact on the size of your monthly payment.
- Your other debts: Your debt-to-income ratio (DTI) shows the lender how many other obligations you have in addition to the loan you’re applying for. Many lenders prefer a DTI of 35% or less.
- Your income: The lender will want to know you have stable income that is sufficient enough to make payments so you can repay the loan.
Simple vs. compound interest
Whether interest is simple or compound makes a difference in how you calculate it and how much you’ll pay.
- Simple interest is determined by multiplying the interest rate by the amount you owe. But it’s not necessarily “simple.” If you pay the balance down monthly (which most of us do), interest is computed based on the new (reduced) principal balance each month, instead of in one lump sum at the end of the year. Since these loans also have set repayment terms, lenders use a process called amortization to set an equal monthly payment — you pay less in interest and more toward principal every month, but your payment stays the same. Personal loans often have simple interest, as do auto loans, student loans, and mortgages.
- Compound interest is more common with revolving debt. Instead of only calculating interest on the principal, you calculate interest due on the principal plus any accumulated interest. Interest may be compounded daily, weekly, monthly, annually, or at some other interval, depending on the lender and type of debt. Credit cards often use compound interest.
FAQ
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