If you've ever applied for a loan, one thing that might be confusing is APRs and interest rates. At first, it might seem like these two numbers are the same thing. But take a closer look and you'll find that they represent different aspects of the loan. In this article, we'll explain the difference between APRs vs. interest rates, and why it's important for borrowers to understand them.
Interest rates vs. APRs
To better help you understand APRs and interest rates, it will be helpful to first define each term:
The interest rate is the number that's used to calculate your loan. It's what gets applied to the money you borrow (called your principal) and can be factored over several years (such as a 30-year mortgage).
Typically, the better your credit score, the better the interest rate you'll be offered by the lender. This is important because the interest rate has a direct impact on the overall cost of the loan.
APR stands for annual percentage rate and includes the fees involved with borrowing the money. These might include origination fees, closing costs, and maintenance fees. The APR also condenses the overall cost of the loan into just one year.
APRs are used for comparing loans from one lender to the next. Since the APR is the output of the interest rate, fees, and other variables, it does not affect the cost of the loan.
Example of interest rates vs. APRs
Let's look at how the interest rate and APR of a mortgage will differ. Suppose you'd like to buy a house for $250,000 using a 30-year mortgage. Although the interest rate used to calculate the loan is 3.25%, the calculated APR will be 3.53%.
For personal loans, you might find three different offers with the same 8% interest rate. But if each one has a different origination fee and loan length, then they will all have different APRs.
Generally, an APR will be more than the interest rate because of the fees involved. But because the APR captures the costs and frames the rate as a yearly cost, it makes a better metric for comparing offers.
What you can't tell from a loan's APR
While APRs are useful to know, keep in mind that they don't tell you everything about the loan. Here are a few factors to consider as you're deciding which loan is right for you:
- Variable interest - Interest rates can either be fixed or variable. When a rate is variable, it will fluctuate at the discretion of the lender. The lender can tell you what the current APR is, but this number may not be helpful because it will change the moment the interest rate also changes.
- Term lengths - Even though the APR will be calculated with the term length included, it will be impossible for the borrower to know what number was used. Since the term length can have a big impact on how long it will take to pay back the loan and the overall interest paid, borrowers should ask for these details.
- Not all fees are included - While the APR takes into consideration some fees like the origination fee, it will not include others. For example, mortgage APRs often don't include fees for the title, notary, document preparation, and home inspection.
The bottom line
While an APR and interest rate may sound similar, they each have different roles. The interest rate is what's used to calculate the loan, and the APR includes major fees. Use the APR to compare loans offered by different lenders and choose an option that works for your budget and needs.
Notice: Information provided in this article is for information purposes only. Consult your financial advisor about your financial circumstances.
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