APR and interest rate are terms that get bandied about in personal finance circles a lot. They’re both measures of how much you’ll pay to obtain money, but they measure different things.
Have you ever come across a scenario where the interest rate on your credit card is higher compared to the APR on certain loans and found yourself questioning the reason behind it? The purpose of this article is to shed light on the distinctions between APR and interest rates.
It also includes the methods of their calculation and gives a clear understanding of the distinctions between the two. We'll also explain why one might be higher than the other!
What Interest Rate Is
Interest rates refer to the amount of money that a lender charges a borrower for the use of money over a certain period of time. As an illustration, when acquiring a mortgage, a lender will require you to pay interest on the borrowed funds.
The interest rate, which will be added to the principal amount borrowed, is frequently expressed as a percentage of the total loan value. The interest rate may also be stable, which indicates that it will not change during the loan's term.
They can also be variable, meaning they can change based on various factors, such as market conditions. In a nutshell, the cost of lending cash can be referred to as interest rates.
How Is Interest Rate Calculated
These rates are typically calculated based on a combination of factors. This includes the lender's risk assessment of the borrower, the terms of the loan, and the current market conditions.
For example, if you want to take out a loan to buy a house, the lender will consider your credit score, income, debt-to-income ratio, and other financial factors to determine the level of risk associated with lending you money.
A lender may grant you a favorable interest rate if they perceive you to be a low-risk borrower with a strong credit score and a steady income. Alternatively, borrowers with weak credit scores or significant outstanding debt may incur a higher interest rate since lenders may view them as high-risk.
The terms of the loan, such as the loan amount, the length of the loan, and the type of collateral used to secure the loan, can also affect the interest rate. Finally, market conditions, such as the overall state of the economy and the demand for lending, can influence rates.
What APR Is
The Annual Percentage Rate, commonly known as APR, is an indicator of the cost incurred when borrowing funds, which is represented in a yearly percentage value.
It is used to help borrowers compare different loans and lenders, as it takes into account not only the interest rate on the loan but also other fees and charges that the borrower may be required to pay. It includes the interest rate, points, mortgage broker fees, and certain other credit charges that the borrower is required to pay off.
For example, let's say that I'm planning to obtain $10,000 from my bank at 8% interest over five years (60 months). That would add up to about $2160 in additional costs over those five years!
In general, APRs are expressed as a percentage and are calculated by dividing the total cost of getting the loan amount, then multiplying by the number of days in a year. In this way, different loans can be compared in a standard way. This allows for easier comparison of loans based on their overall costs.
What Is a Good APR?
A good annual percentage rate is one that is lower than the average APR for the type of loan you are considering. It is common for personal loans to have an interest rate of around 10%, while credit cards may have an interest rate of around 20%.
In essence, a personal loan with an annual percentage rate (APR) of 8% would be deemed favorable if you're contemplating obtaining such a loan.
It is essential to keep in mind that not all APRs are equal. Your income and credit score, among other personal financial factors, may influence the APR you are offered for personal loans. Additionally, it's crucial to evaluate the loan's terms and any additional expenses that may be included, as they can influence the overall expense of the loan.
How Is APR Calculated
The annual percentage rate, or APR, is determined by dividing the total cost of borrowing, including any added fees or charges, by the sum of the loan. This amount is then multiplied by the total number of days in 1 year (365) and expressed as a percentage.
For example, if you take out a mortgage loan for $10,000 with a rate of 5% and an origination fee of $100, the total cost of borrowing the money would be $500 (5% of $10,000) + $100 = $600. If the loan has a term of one year, the APR would be calculated as follows:
APR = ($600 / $10,000) x 365 = 6.48%
This means that the overall cost of borrowing the money, including both the interest and the origination fee, is 6.48% per year.
It's worth highlighting that APR may fluctuate as per the nature of the loan, lender and borrower's individual financial circumstances.
What’s the Difference Between APR and Interest Rate?
When it comes to understanding the distinction between APR and interest rate, it's important to keep in mind some key things. The first difference is that the APR includes all costs connected with borrowing money, whereas the interest rate simply covers the cost of the loan's interest.
The interest rate is a proportion of the loan amount that the lender charges the borrower for utilizing the money for a set period of time. APR, on the other hand, considers not just the interest rate but also any other charges and fees imposed by the lender (such as origination fees and closing costs).
For example, if you obtain a loan with a 5% interest rate and a $100 origination charge, the APR is computed by combining the interest and the origination fee and expressing the amount as a percentage.
Though they are not identical, APR and interest rate are closely connected and can be used to evaluate the cost of borrowing from different lenders. When comparing loan alternatives, it's critical to consider both the interest rate and the APR to ensure that you're receiving the best deal possible.
|
Feature |
APR |
Interest Rate |
|
Definition |
Annual Percentage Rate |
% of the loan charged by a lender |
|
Calculation |
Total cost of borrowing (interest rate + additional fees/charges) divided by loan amount |
% of the loan charged as interest |
|
Comparison |
Useful when you compare different offers |
Useful when comparing interest charges on loans |
|
Evaluation |
It is essential to take into account APR when evaluating loan options |
It's important to consider interest rate when evaluating the cost of borrowing |
|
Impacted by |
Credit score, income, other financial factors |
Credit score, market conditions, loan amount, creditworthiness |
Why Is APR Higher Than the Interest Rate?
APR is usually higher because it includes additional fees and charges that may be associated with the loan. An origination fee may be charged, as well as closing costs and other charges.
For example, if you take out a loan with a rate of 5% and an origination fee of $100, the APR would be calculated by adding the interest and the origination fee together and expressing the total as a percentage.
This implies that the APR will be greater than the rate because it includes the cost of the origination charge (in addition to the interest).
It's important to note that not all loans have the same fees and charges, so the annual percentage rate can vary widely, even for those with similar rates. It's a good idea to compare the APR as well as the interest rate when looking to obtain a loan. This will ensure that you are getting the best deal possible.
Conclusion
To summarize in a few words, APR is the interest rate plus some extra fees and charges. It’s a way for lenders to make more money from you without charging higher rates. While it may seem like they're charging you more than they need to with this extra fee, in reality, it's just another way of calculating how much money they will make off your loan agreement over time.
