What is an interest rate?
When you use a credit card, take out a student loan or apply for a mortgage, the lender charges you interest, which is expressed as an annual percentage of your loan balance.
Simply put, interest is the basic cost of borrowing money.
Your interest rate can be variable (meaning it can change over time) or fixed (meaning no changes ever), and the rate you land is determined by factors including your credit score and how much money you're borrowing (your principal).
There are two types of interest: simple interest and compound interest.
The majority of loans utilize simple interest, which is very straightforward and easy to understand, but credit cards complicate things by charging compound interest. That is, you pay interest on the interest itself.
What is APR?
With most types of loans, like personal loans, mortgages or auto financing, APR — not to be confused with the APY on deposits — refers to your yearly interest rate rolled up with some of the additional costs of taking out the loan.
Credit cards are the exception. With credit cards, your APR and the interest rate are the same thing, and are used to determine how much extra you'll owe when you carry a balance on your card from month to month.
But with other kinds of loans, think of your interest rate as the base cost of borrowing money month to month, while APR refers to a total cost of borrowing, once fees and expenses are included.
You can expect administration and loan-processing fees to be included in the APR. But lenders don’t need to include all costs in the APR; mortgage APRs normally don't bake in costs such as the appraisal and credit report fees.
When you’re comparing loan terms, looking at APRs isn’t enough — you need to ask the lender to disclose all the costs involved so you can get the clearest picture.
Understanding the difference between interest rate and APR
On any mortgage, the APR will be higher than the interest rate, because the APR is your interest and more.
The "and more" includes loan origination fees (for processing the loan), mortgage insurance, most closing costs and "discount points."
Points are fees paid to the lender at closing in exchange for a lower interest rate; 1 point is typically equal to 1% of your loan amount and cuts your rate by 0.25.
Here's an example of how APRs and interest rates compare on mortgages. Let's say you want to buy a $200,000 home, and your choices are:
- Loan A, which has an interest rate rate of 3.25%, no points and $3,000 in other lender fees. The fees turn the interest rate into an APR of 3.37%.
- Loan B, which has an interest rate of 3%, 1 discount point costing $2,000, and $3,000 in other lender fees. The point and other fees turn the interest rate into an APR of 3.20%.
Interest rates between the two loans differ by a quarter point (0.25). But when upfront costs are part of the equation, the difference in APRs is smaller (0.17).
Using interest and APR to choose a loan
Still, Loan B has the lower interest rate and APR, meaning you'd pay less over time in terms of principal, interest and fees than you would with Loan A.
But Loan B isn't necessarily the right choice. As reflected in the APR, the loan has more frontloaded costs, including the discount point. Your monthly savings from the lower interest rate and APR will have to pay off those costs before you "break even" — and really save any money on the deal.
If you may be moving out within a couple of years, Loan A, with its lower costs, may be the smarter choice. If you're in the house for the long haul, Loan B makes sense.
To make the choice, you have to calculate your break even point: the amount of time it will take you to pay off Loan B's additional costs with help from the reduced rate.
- Loan A — in the amount of $200,000 and at 3.25% — would have a monthly principal and interest payment of $870.
- Loan B — in the amount of $200,000 but at 3% — would have a monthly principal and interest payment of $843.
Loan B would save you $27 a month. But with those savings, it would take you 74 months — more than six years — to break even on the extra $2,000 in upfront costs (namely, the discount point) associated with that loan.
If it's likely you won't be sticking around in the house that long, Loan A would be the better way to go.
While your interest rate is driven largely by the market and your credit score, the APR includes items like lender fees and discount points, which you have more control over — and can often be negotiated.
Typically, you’ll want an APR that isn’t far from the advertised interest rate. If the APR is much higher, it could be a red flag that there are lots of fees being charged.
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