In a nutshell
- The interest rate is the cost you pay on the money you borrow from a lender
- The APR includes the interest rate plus the lender fees added to your payment
- APR will almost always be higher, unless the lender is offering a discount
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What is the difference between interest rate and APR?
Your interest rate is the cost of borrowing money, without taking fees into account.
If you borrow $100,000 dollars, your lender will charge you a percent of the money you borrow as compensation for lending you the money.
However, there are fees on top of interest that a borrower is often required to pay. Some of these are included on top of the loan, and are expressed as a percent of the loan. When added to the interest rate, this percentage is referred to as the APR.
Your APR is the total annual cost of your loan, including fees. On many loans, the APR will be higher than the interest rate because it incorporates these additional costs — things like sundry loan fees (for processing the loan), mortgage insurance, closing costs, and discount points.
Is it better to get a higher interest and low APR, or lower interest and high APR?
Knowing which combination of interest rate vs. APR to choose largely comes down to the length or term of your loan. Consider the example below:
In this example, we compared two different loans. Both loans have a $100,000 principal, are calculated using compound interest, and use monthly payments.
The bar graph illustrates the total payments made to the lender over the term of the loan. It includes the principal, the interest and the APR fees.
As you can see, Loan 2 is cheaper with shorter loan terms, but as the loan term increases, the difference between the two loans shrinks. Eventually, when the term passes 15 years, Loan 1 becomes the cheaper option.
This can occur when APR fees are stretched over a long period, which results in a lower monthly payment than the borrower would pay with the higher interest rate.
The difference between the two loans at the 30-year term is $5,027 ($323,658 - $318,630) — enough to pay for a week-long vacation in the Caribbean!
When it comes to choosing a loan, making the right decision can save you thousands.
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Fees that are included in APR:
- Prepaid interest — The interest paid from the date the loan closes to the end of the month. If you close on August 10th, you will pay 21 days of prepaid interest.
- Mortgage points — Fees paid directly to a lender in exchange for a lower interest rate.
- Administration fees — Any fees related to administering your loan, including underwriting, processing fees, and application fees.
- Escrow fees — Fees from the lender’s lawyer or legal team to cover paperwork and the exchange of funds.
- Private mortgage insurance (PMI) — A type of insurance that conventional mortgage lenders require when the down payment is less than 20%.
- Credit life insurance — A type of insurance that pays off the borrower’s loan in the event of their death.
Fees that are not normally included in APR:
- Title or transfer fees
- Lawyer or notary fees incurred by the borrower
- Documentation fees incurred by any third party or lending agent
- Home-inspection service fees
- Engineering fees
- Property or land-transfer taxes
- Credit report fees
- Home or property appraisal fees
- Realtor fees
What is an interest rate?
As noted above, your interest rate is the cost of borrowing money. You borrow money when you finance a car, use your credit card, mortgage a home, and use a line of credit. The largest cost of borrowing money is your interest rate, which can vary from as low as the prime rate to as high as 20% or 30% on some credit cards.
Your interest rate can be adjustable (meaning it can change over time) or fixed (meaning it won’t ever change). The rate you negotiate is determined by a few factors, including your credit score and how much money you're borrowing (your principal).
For example, if you borrow $100,000 dollars, your lender will charge you a percent of the money you borrow as profit to them for loaning to you. Let’s use 7% as an interest rate on that $100,000 you borrowed. The cost for borrowing would be $7,000 (0.07 x 100000 = 7,000). The cost you would pay back to your lender is $107,000.
However, if your APR is different from your interest rate — and it almost always is — that means there are fees on top of your interest rate that you are required to pay, but will be amortized over the term of the loan. This total percent is referred to as the annual percentage rate and is the total cost to borrow money.
How are interest rates calculated?
There are two ways to calculate interest in the United States.
The simple interest calculation is a common way to calculate the interest on most loans, with the exception of mortgages and credit cards. The simple interest calculation is the same as the example we used above, where the lender multiplies the amount borrowed by the interest rate to arrive at the cost of borrowing money. For example if your friend loans you $10,000 for a year and wants to earn $200, then the interest rate on that loan is 2%. Simple, right?
What types of loans use simple interest?
- Personal loan
- Student loan
- Retailer payment loans
Compound interest is a calculation where changes in your loan balance are included in the interest calculation. So, if you make monthly payments on a mortgage, the amount of interest you pay each month is recalculated based on the new balance of your mortgage. The opposite is also true; if your loan balance increases — on your credit card, for example — the amount of interest you pay is recalculated based on your new loan balance.
What types of loans use compound interest
- Line of credit
- Credit card
Some loan terms borrow features from both simple interest and compound interest. For example, all mortgages use the compound interest calculation so that your interest is recalculated after you make payments. This results in the borrower paying less interest than if a simple interest calculation was used. However, any missed payments are treated like simple interest and charged a late fee, instead of just rolling into the remaining balance of the loan. Thus, the rest of the loan amortization schedule is allowed to continue like no payment was missed and the late payment is dealt with separately.
What is APR?
Almost all loans are expressed as an annual percentage rate, or APR. Even simple interest loans are often expressed this way, so it’s important to read the terms of your loan so you know exactly what you’re getting into.
If a loan has an APR, by law it must also disclose its interest rate. The purpose for displaying both is so you can see what portion of the APR is interest vs. fees. Sometimes the interest rate and the APR are the same. Credit cards typically have the same APR and interest rate, since their fees are often part of a yearly credit card fee and not included in the APR.
A number of loan fees are included in the APR, but there are also many that aren’t. For example, a lender may need to run a credit report for you as part of the loan application, and credit reports aren’t usually part of an APR.
When you’re comparing loan terms, looking at APR isn’t enough. You need to read your loan agreement and ensure that the lender has disclosed all of your costs upfront so you can make an informed decision.
Why is APR higher than the interest rate
APR is higher than interest rate because it includes fees that the lender incurs as a cost of administrating a loan. Interest rate is the amount that the lender wants to earn on the money they loan to you. The interest rate plus the administrative fees is called the APR.
How to calculate APR
APR starts with the interest rate, which is the amount that the lender wants to earn on the money they lend to a borrower. Any additional APR costs are added up and expressed as a percentage of the total loan amount.
For example, if you are borrowing $10,000 and your PMI is $100 and your loan underwriting fees are $75, then your total fees are $175 (100+75). You then divide 175 by your loan amount of 10,000 to give you 1.75%. If your interest rate is 4.5%, you would add 4.5% and 1.75% to arrive at your APR of 6.25%.
What is a good APR?
This depends on the loan type. An APR below 10% on a credit card would be very good, but a 10% APR on a mortgage would be quite high. In the case of credit cards, the APR is usually the same as the interest rate — but that's not the case for mortgages. So, if you have a 10% mortgage rate, your lender is likely charging you a lot of fees. That’s why it’s important to be able to see the interest rate vs. the APR; it will show you whether the fees your lender wants to charge you are too high.
Does APR vary by loan type?
Yes, APR varies by loan type. Interest rate is tied to loan risk; the less likely it is that the lender will get their money back, the higher the interest rate. For example, credit cards have a very high interest and APR because the barrier to getting a credit card is very low. Almost anyone is eligible to qualify for a credit card, including someone who may be unemployed, so the risk is high that the credit card company may not get its money back. Additionally, annual credit card fees are not rolled into the APR, but are charged directly to the customer as a separate fee, so the difference in credit card interest rate vs. APR is usually nothing.
A mortgage, on the other hand, is considered low risk for the lender, since it is secured (backed) by the value of your house. That means the interest and the APR on a mortgage is considerably lower than on a credit card. And unlike credit cards, mortgages carry no annual fees, because fees like underwriting and home appraisal that the lender incurs are rolled into the APR.
How low can APR be?
APR can vary greatly depending on the type of loan. Although APR is typically higher than the interest rate, sometimes it can be lower. For example, in a no-closing-cost refinance mortgage, the difference between APR and the interest rate will be nothing, since there are no closing costs to roll into the interest rate.
What happens to my APR and interest rate if I pay off my loan early?
It is possible to pay off your loan early, but you also need to remember that there are fees associated with your loan which the lender has rolled into your APR. If you pay off your loan early — paying off a two-year loan in one year, for example — your lender is only receiving 50% of the administration costs that they’ve rolled into your APR. They are also only receiving 50% of the interest they were expecting to collect from loaning you money. Many loan terms account for this and will issue a prepayment penalty fee if you pay off your loan early.
Before paying off your loan early, you’ll want to evaluate the cost you are paying to keep the loan until full term vs. the prepayment penalty fee so you can decide which option is cheaper.
How to get the lowest APR and interest rate
Getting the lowest APR and interest rate depends on a few things.
Your credit score is the most important factor. A low credit score is riskier to the lender, so to offset the risk, they offer higher interest rates to lower credit score individuals.
More: Get your free credit score from Credit Sesame
Loan to value
Another important factor is the amount of downpayment you bring to the loan, or the portion of the principal that is secured by a house or other asset. In other words, does a mortgage make up 95% of the value of your home or 50%? If the value of the loan you are seeking is small compared to the value of the asset you’re purchasing, then the risk to the lender will be low since the likelihood that they will recover their money is high. As a result, they will charge a low interest rate. This is called loan to value, or LTV. Adversely, if the LTV is high, the interest rate will also be high.
A third important factor in achieving the lowest APR and interest rate is to understand the terms of your loan. Lenders and brokers loan money to make money, so it is important to advocate for yourself and understand the terms of your loan so you can make an informed decision about the loan options that are best for you.
Can you deduct your interest and APR?
Individuals cannot deduct the interest or APR of a loan, but businesses can. Interest and APR fees are considered a cost of doing business, and thus can be included as an expense on a business income statement and cash flow statements. However, the principal that a business pays back is not deductible; this is not considered an expense. Instead, this is added to the balance sheet as a long-term account payable and amortized over the term of the loan.
If you are shopping for a loan, the most important thing is to be armed with knowledge. The more you know about the financial products you seek, the better decisions you’ll make — and the more money you’ll save!
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