Whenever you are borrowing money, whether it’s for a new mortgage, a refinance, credit card, or car loan, you’ll hear the terms interest rate and APR discussed quite a bit. Both of these terms are expenses, and it’s important to understand what each expense means and what they are made up of. What is the difference between interest rate and APR? We’re glad you asked
What Is an Interest Rate?
The interest rate is simply the annual cost associated with borrowing the principal balance from a lender. Interest rates are present on various different types of loans, including; mortgages, credit card balances, car loans, student loans, and even personal loans.
Lenders are in the business of making money, and charging an interest rate on the money lent allows them to do so. Borrowers will be required to pay back the principal balance plus the associated interest rate with the loan
How Does an Interest Rate Work?
Understanding how the interest rate works is also important. Some loans have a fixed interest rate, which means for the duration of the loan the interest rate percentage does not change. Other loans have a variable rate, or adjustable interest rate, which means the rate is subject to change over time.
The lower the interest rate is, the less money the borrower has to pay back. The higher the interest rate, the more expensive it is to actually borrow money from the lender. Credit card debt has a notoriously higher interest rate, whereas mortgages tend to have lower interest rates.
How Do Interest Rates Get Calculated?
There are various ways interest rates get calculated. We’ll address three of the most common.
First and foremost, interest rates can be derived from an associated risk equation. If one has a lower credit score, a high debt to income ratio, or an unstable financial history, the lender may view them as a higher risk of defaulting on the loan. To adjust for that risk, the borrower will charge a higher interest rate on the borrowed money if in fact the loan was approved.
Conversely, if the borrower is in a solid financial position, and has a history of paying debt back in full and on time, the lender may not view that borrower as a risk of defaulting on the loan. For that reason, the lender may charge a lower interest rate on the borrowed money.
Secondly, the time of the loan can also affect the interest rate. The longer the loan is, the more risky it can be considered - which results in a higher interest rate. The shorter the loan is, the easier it is for a lender to predict what will happen to the economy or one's financial situation, and will tend to charge a lower interest rate.
Last but not least, market conditions will impact interest rates. The government can pull various levers that will cause the interest rate to change. At a time where consumers are scared to spend money, the government may put policies in place to lower interest rates, resulting in consumers gaining confidence to spend. If consumer spending is high and the economy is thriving, banks and the government may raise interest rates. Various macro and micro economic factors will all influence interest rates, not only in the mortgage industry but in the overarching lending market.
What Is APR?
Now that we’ve covered interest rates, let’s dive into what APR is and why you should care.
APR in an acronym for annual percentage rate. Said differently, APR is the total cost associated with borrowing money yearly. This is a more encompassing way to measure the true cost of borrowing money from a lender.
How Does APR Work?
The annual percentage rate (APR) is made up of; the interest rate, any fees associated with borrowing money, any discount points the lender associates with the loan and various other charges you’ll be required to pay on the loan.
How Does APR Get Calculated?
APR gets calculated by adding up the total principal balance of the loan, the interest rate on the loan, and the various fees associated with the loan into one final total. Once that number is finalized, you divide that number by the duration of the loan, and convert that total into a percentage of the total loan value.
A $300,000 loan that has $10,000 in fees and a 4.5% interest rate actually has an APR of 4.71%. The 4.71% is the true cost of borrowing money, and as shown, the APR is always greater than the interest rate.
Calculating the numbers by hand or excel is a thing of the past. There are various online calculators that can help you understand your true APR rate by just inputting a few numbers.
How Do I Calculate APR From Interest Rate?
The interest rate is needed to calculate the annual percentage rate because the interest rate is added to the total fees paid, and the principal balance, to get one final aggregated number. From there, that total is divided by the number of days in the loan, multiplied by 365 and again divided by 100 to convert that number into a percentage. That percentage is your APR.
Is It Better to Have a Lower Interest Rate or a Lower APR?
Generally speaking, the APR is a more accurate representation of the true borrowing cost of the loan. The lower your APR is, the less expensive it was to borrow the money.
A lower interest rate may be easier on the eyes, as the monthly payment will likely be lower, but don’t be fooled. There may be high fees or costs associated with borrowing, which allows the lender to offer a lower APR
Does 0% APR Mean No Interest?
There are various times a lender may offer a 0% APR. The 0% APR is generally for a limited period of time, meaning the borrower may borrow the money for 12, 18, or even 24 months interest fee.
Once the time period has elapsed, interest becomes relevant with the loan and the borrower will be required to pay the interest expense associated with borrowing.
Now You Know the Difference!
There are certainly a lot of terms and acronyms in the mortgage, finance, or lending field. As a borrower, it’s important to fully understand what these terms are, and how they can impact your monthly payments.
Remember, the interest rate is the cost to borrow the principal amount of the loan, but it does not factor in all expenses. For a more encompassing and detailed understanding of the borrowing cost, use the annual percentage rate, or APR.
The APR is the fully baked financial metric that factors in the all in cost of the loan. The APR will add in the interest, closing fees, and broker fees into one aggregated sum, and divide that amount over the lifetime of the loan. That payment is converted in a percentage, which you’ll know as the APR.
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This page last updated: October 6, 2022