Lenders quote loans in terms of both the interest rate you pay and an annual percentage rate (APR). They’re both important measures of a loan’s cost, but they account for different charges. Understanding how they work helps you choose the right loan.
Interest Rate vs. APR
Both the APR and a loan’s interest rate describe the cost of borrowing.
- The interest rate is the percentage lenders charge on your outstanding loan balance, usually expressed on an annual basis.
- APR includes not only annual interest charges but other additional fees and costs required to get a loan. As a result, it should provide a more accurate description of your total cost.
How Interest Rates Work
An interest rate is a number lenders apply to your loan balance. For example, if you borrow with a 5% interest rate, lenders charge $5 each year for every $100 you borrow.
The Lower, the Better
All other things being equal, a lower interest rate is best. Your interest rate (among other things) affects your monthly payment: The higher your rate, the more you pay each month.
When you pay interest, that money is gone for good. Interest does not help you build equity or eliminate debt the way payments on the principal do.
Interest costs effectively increase the total cost of whatever you buy with your loan proceeds.
In practice, lenders might apply interest charges more often than annually.
For example, standard mortgage loans charge interest monthly. Using the 5% rate above, you don’t pay 5% on your loan balance each month. Instead, you pay a monthly rate that’s 1/12th of your annual rate.
How APR Works
An APR, like an interest rate, is a rate lenders usually quote as an annual amount. The APR includes the interest rate you pay on the debt, as well as costs related to funding your loan.
As a result, the APR provides an all-inclusive cost of borrowing, enabling you to compare lenders who charge different fees and different interest rates.
For example, you might pay closing costs for a mortgage loan, including:
- Origination fees
- Application fees
- Discount points
- Private mortgage insurance (PMI)
- Other financing fees
An APR combines those costs with your interest rate into a single number that estimates your cost of borrowing.
The loan with the lowest APR is often the best choice. But there are several exceptions to that rule.
APR helps you make an apples-to-apples comparison among lenders.
One lender might charge a higher interest rate with no closing costs, while another lender may have low rates but require several thousand dollars upfront. The APR can help you determine which loan might have the lowest costs.
Lenders are required to provide an APR for most home loans. You can find that information, as well as details about closing costs and interest rates, in your Loan Estimate.
Some Fees Not Included
An APR includes several critical charges, but it doesn’t account for every charge required to get approved for funding. For example, a credit report fee might not be part of the APR calculation.
No matter what APR is listed on your loan information, you should always read your paperwork thoroughly to know exactly what you are paying.
Using Interest Rate and APR to Choose a Loan
When you get a loan, your APR and interest rates may be slightly different or the same.
If you don’t pay any fees to borrow, your APR is the same as your interest rate. But when you pay fees, you end up with an APR that’s higher than your interest rate.
Even when multiple loans have the same interest rate, they can end up with a different APR. If the fees required to fund each loan are different, the final APRs will differ as well. In that case, the loan with the highest fees will have the highest APR.
For example, if you want to borrow $250,000 for a 30-year fixed-rate home loan, you might receive two similar quotes.
|Comparing Loans With Different Interest Rates and Fees|
|Loan A||Loan B|
Note that a point is an optional fee that lowers your ongoing interest rate. Each point is 1% of your loan balance ($2,500 in this case).
For Loan A, you must pay $5,000 in points plus $1,545, for a total of $6,545. That might seem steep compared to Loan B, which only requires $500. But Loan B comes with a higher interest rate, so you’re paying costs over time instead of at the beginning of your loan.
In this case, if you plan to keep the loan for the full term, Loan A appears to be a better deal even though the upfront fees make the APR higher.
When Low APR Isn't Best
The loan with the lowest APR isn’t always your best option. Depending on the upfront fees, the type of loan you use, and how you pay off debt, a higher APR could work out better for you.
Aggressive Debt Payoff
If you plan to pay off debt quickly, it may be best to minimize upfront fees, because you might not keep the loan long enough to benefit from the lower interest rate that comes with those fees.
In the example above, Loan A has a lower interest rate but requires $6,545 upfront. If you intend to pay significantly more than the minimum, you might save money with Loan B (and you can put the $6,045 that you’ll save in fees toward debt reduction).
The only way to know for sure which rate is better is to run some what-if scenarios with an amortization schedule.
Refinancing or Selling
In terms of its impact on your overall costs, selling your home or refinancing your mortgage is equivalent to paying off the debt quickly. Estimate how long you’ll keep your current loan as you evaluate upfront costs.
Adjustable-Rate Mortgages (ARMs)
ARM loans can also make it hard to evaluate APR. When you receive a quote from your lender, you see the APR at that moment. But the interest rate on an ARM can change (thereby changing the APR).
In addition to comparing the starting rates, you need to understand how quickly rates can change with each loan.