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APR vs. interest rate: What’s the difference?

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You may already know that interest is the cost of borrowing money. Borrowers pay interest when they take out loans or lines of credit to cover expenses. The terms APR and interest are often used interchangeably to refer to the cost of borrowing, but these terms mean different things. While interest is the cost of borrowing, annual percentage rate (APR) includes interest plus certain fees associated with the loan, and APR represents the rate over one year.

Here’s what we’re going to cover:

  • What is APR?
  • How is APR calculated?
  • What is an interest rate?
  • How are interest rates calculated?
  • Differences between APR and interest rate
  • Why is APR higher than the interest rate?
  • What are good APRs and interest rates?

Key takeaways

  • APR and interest are sometimes used interchangeably, but these terms don’t mean the same thing.
  • APR accounts for the interest rate on a loan or credit card as well as any fees or charges associated with borrowing.
  • APR gives borrowers a better understanding of the cost of borrowing.
  • APRs are a tool used for comparing costs of different loans or credit cards and should be reviewed before applying.

What is APR?

APR (or annual percentage rate) represents the total cost of borrowing money on an annual basis. It includes the interest rate on the loan and any additional fees or costs associated with obtaining the loan. For example, a personal loan APR may include origination fees or application fees, though it wouldn’t include fees for late payments. APR provides a more complete picture of the cost of getting a loan than the interest rate alone.

It’s important to note that credit cards may have different APRs for different charges. Your credit card may have a purchase APR, a balance transfer APR, a cash advance APR, and sometimes an introductory promotional APR.

Since APRs are an annual expression, APRs can be confusing when talking about loans with repayment periods less than a year because it extrapolates the cost as if the loan is one year. Further, when the repayment period changes by numbers of years, APRs can also go up or down: A longer repayment period will have a lower APR. When using APRs to compare various loans, make sure the repayment periods are similar to get a real sense of the cost difference.

How is APR calculated?

Lenders determine your APR using a formula that includes interest charges, fees, loan principal, and the loan term:

APR = ((Interest charges + fees) / Principal / n x 365) x 100

Add the loan fees to the interest, then divide the sum by the principal, and then the number of days in the repayment term. Multiply the result by 365 and then 100 to arrive at your APR.

What is an interest rate?

Interest is the cost of borrowing your loan without any fees or additional costs. It is factored into the APR. Interest is expressed as a percentage and may vary based on the financial product in question. Interest rates can be influenced by the federal funds rate set by the Federal Reserve. The rate of interest offered to borrowers may change based on any changes to the federal funds rate.

How are interest rates calculated?

There are two main types of interest: simple and compound interest. Simple interest is calculated using the initial loan size or at the beginning of the term and doesn’t change over time. It’s usually applied to traditional mortgages, car loans, and personal loans.

Compound interest is calculated on the initial loan size but adds interest to the loan size if the balance is unpaid, essentially meaning you’ll pay interest on interest. It is typically applied to credit card balances.

Simple interest: Simple interest is calculated on the initial principal amount over a specific period. The formula for calculating simple interest is:

Simple interest = Principal × Rate of interest × Loan term in years

Compound interest: Compound interest considers the initial principal and the accumulated interest over previous periods. The formula for calculating compound interest is:

Compound Interest = Principal [(1 + interest)n] – Principal

N represents the number of compounding periods.

Differences between APR and interest rate

Learning the differences between APRs and interest rates can help you better understand the cost of borrowing and how to pick the right financial products. Here are a few ways these rates differ:

  • Definition and scope: Interest rates don’t include fees, while APRs do. A loan APR will give you a more complete picture of how much you’ll owe once you’re approved for a loan.
  • Flexibility: Interest rates often take into consideration the borrower’s credit score (creditworthiness), but the lender controls APRs. A lender is unlikely to offer you a lower interest rate unless you raise your credit score. However, they can lower your APR by waiving certain fees (such as origination or application fees).
  • Cost indication: Interest indicates the basic cost of using borrowed funds, while APR helps borrowers understand the true cost of a loan by incorporating both the interest rate and any associated fees. A low interest rate may not mean much if the lender adds on high fees and charges.
InterestAPR
DefinitionIndicative cost of the loanTrue cost of the loan
FlexibilityUnlikely to change for an individual unless their credit score changes over timeMay change based on factors like lender’s leniency and promotional offers
Cost indicationProvides an idea of the cost of a loan, but is not useful as a comparison metricAn effective way to compare the affordability of different loans, especially when the repayment periods are similar

Why is APR higher than the interest rate?

APR is composed of more elements than interest. Additional fees included in APR may be origination fees, discount points, and potential broker or agency fees. These costs are added to the principal balance, but they’re not accounted for by interest alone. Including them in the APR causes the APR to be higher than interest. APR may occasionally be the same as stated interest (if there are no additional fees and costs), but it’s never lower.

What are good APRs and interest rates?

When shopping for a loan, it’s a good idea to seek out the lowest APRs you can find and compare the terms. For loans with similar repayment periods, a lower rate means you’ll pay less interest over the life of the loan. This reduces the overall cost of borrowing, making the loan more affordable. Consider getting pre-approved so you can compare the rates and terms available to you before choosing a loan.

Oportun: Affordable lending options designed with you in mind

Now that you understand the differences between an interest rate and APR, you can learn about how Oportun may be able to help you if you’re looking for affordable credit options. Visit our homepage to learn about:

  • Personal loans
  • Credit cards
  • Secured personal loans
  • And more!

Sources

Investopedia. Interest Rate vs. APR: What’s the Difference?

Investopedia. Annual Percentage Rate (APR): What It Means and How It Works

Ent Credit Union. How to Calculate Compound Interest: A Comprehensive Guide & Calculator

Investopedia. Simple vs. Compounding Interest: Definitions and Formulas

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