When it comes to finance, two terms that are commonly used, but frequently misunderstood, are APR and interest rate. While both APR and interest rate are used to describe the cost of borrowing money, they are not the same thing. Understanding the differences between APR and interest rate can help you make better financial decisions in the long run.
An interest rate is simply a percentage of the amount of money you borrow that the lender charges you for the service of lending you the capital. The interest rate is the cost of borrowing the money but does not include any additional fees that the lender may charge you. In short, the interest rate represents the rate at which the loan accrues interest, and it varies depending on the loan’s terms, the lender, and factors such as your credit score.
Annual Percentage Rate (APR)
APR is a term that is frequently used interchangeably with interest rate, but it is not the same thing. APR considers both the interest charged as well as any additional costs or fees associated with the loan. These fees can include application fees, broker fees, underwriting fees, and other charges. The APR is the calculation that provides the borrower with the comprehensive cost of borrowing, including all fees, that will be spread out over the loan term.
For example, let’s say that you get a loan with an interest rate of 5% and an APR of 6.5%. The interest rate would refer only to the percentage of interest on the loan, while the APR includes both the interest rate and any additional fees associated with the loan. The APR is thus typically higher than the interest rate because it includes all costs of the loan.
Why APR matters?
Since the APR takes into account everything else that comes with an interest rate, it’s essential to understand APR when comparing loans from multiple lenders. Comparing APRs will give you a much more accurate view of the overall costs associated with each loan, even if the interest rate appears lower. This is especially crucial when considering long-term loans that come with significant fees, as it can result in higher overall costs.
In summary, interest rate is the cost of borrowing money itself, excluding additional fees, while APR considers all costs associated with the loan, including interest rate and additional fees. Understanding the difference between APR and interest rate will help you make informed decisions about your financial situation and will help you to avoid any unexpected costs while taking loans.