When you’re looking to secure funding for something like a mortgage, a new credit card, a car or a personal loan, a lot of terms get thrown at you. Down payments, closing costs, origination fees, APR and interest rate are just some of the terms that borrowers should understand before signing on a loan.
Two of the most commonly misunderstood terms that have an impact on how much your loan will cost are the annual percentage rate (APR) and interest rates.
Using these two very similar terms interchangeably can lead to surprises down the road when you start making your loan payments. Thankfully, the difference between the two terms can be clearly explained, helping you better to understand your position in the borrowing process.
What is APR?
APR is the acronym used for the annual percentage rate. This is a number expressed as a percentage you’ll see on documents outlining the borrowing terms of a loan. Documents for personal loans, mortgages and car financing will all show you APR thanks to the Federal Truth in Lending Act, which set out to create a standard to protect borrowers. All loans and borrowing tools covered under the act must follow the same set of rules when calculating your expected APR.
So, what is APR? APR is the annual cost of your loan, including all associated fees. It is how much money you will need to pay for the year in return for being able to borrow the money you’ve requested. Looking at APRs is a great way to get a better picture of the quality of a loan you’re interested in. If you only look at interest rates when comparing loans, you may be misled about how much your loan will cost as those do not include fees. APR looks to “level the playing field” by giving borrowers the exact cost of the loan with most fees included.
What is an interest rate?
Interest rate is a financial term that expresses what percentage of a loan a borrower will have to pay extra in return for access to borrowed funds. Interest rates can also tell those with savings accounts, CDs, or other interest-bearing financial accounts how much they will earn extra on an account over some time.
For example, if you take out a loan for $10 at a 10% interest rate, you will need to pay back a total of $11 for that loan. $10 would go toward the principal (the amount you borrowed) and $1 would cover the interest (10% of the principal).
It’s important also to be aware that interest rates are not always this simple. You’ll need to know the period of the loan, how often the interest compounds and any other terms the lender includes in the borrowing equation.
APRs vs interest rates
The difference between APR vs interest rate comes down to one word — fees.
“APR represents the annual cost of a loan to a borrower over 12 months. The APR is inclusive of all fees such as mortgage insurance, title reports, application and processing fees, discount and origination points, and any other closing cost fees,” explains David Reischer, Esq., real estate attorney and CEO of LegalAdvice.com. “Interest rate merely refers to the rate at which the money is borrowed, exclusive of any fees.”
The difference between the two figures can play a big role in determining which loan or borrowing tool is best for your situation. As consumers, you should be more concerned with the APR as it gives a more accurate account of what you will pay. Additionally, the Federal Truth in Lending Act requires that all lenders follow the same set of rules when calculating APR, making this number a great tool for comparing two loans on a level playing field. Lenders are not allowed to squeeze or fudge the numbers in a way that misleads borrowers or makes a product look better than a competitor.
The Consumer Financial Protection Bureau lays out key points to be aware of when working with APRs and interest rates. If you’ve received a loan estimate from one or more lenders and need to compare the numbers, the interest rate can be found on page one under the Loan Terms section and your APR will be located on page three under the Comparisons section of the loan estimate. Using these will help you determine which lender will give you a better rate.
The CFPB also advises consumers to be careful when comparing APRs between different mortgages, like a 10-year fixed-rate mortgage, 30-year fixed-rate mortgage or an adjustable-rate mortgage. Often, the APR calculations do not reflect the potential fluctuations in interest rates or all of the associated fees in the same manner. The recommendation given is to look at more than just the APR when making a borrowing decision and to ensure you are comparing similar loan types when looking at APR.
The bottom line
Even though the difference between APR and interest rates is simple, many new borrowers are unsure of the terminology and may be shy to ask for clarification. Unfortunately, this can lead to making incorrect financial decisions when it comes to what borrowing option is best for your situation. Now that you fully understand the difference between the two terms, though, you can best employ them when making financial choices for the future.