When you take out a loan, the interest rate will tell you part of the cost, while APR will reveal your total costs. Most lenders are happy as long as you focus only on the interest rate. Knowing the difference between APR vs. interest rate will help you know if you're taking out a cheap or costly loan.
Experian reports that about 38% of people have a personal loan on their credit report. This statistic shows that millions of people are signing loan agreements. However, most don't know which number shows what they'll pay.
Most borrowers focus on the interest rate and forget about the APR. Lenders know they can attract you with low interest rates, but an APR will show the real costs of your borrowing. If you're thinking of taking a loan, you also need to compare the APRs of different lenders to get a clear picture of what you'll pay back.
What's the APR vs. Interest Rate Difference?
When you're looking to borrow money, you'll need to understand the difference between APR and interest rate. Your interest rate is the percentage your lender charges for borrowing the principal. It only shows the cost of the money itself, without any extra charges.
For example, if you take out a $5,000 personal loan with a 5% interest rate and a 3-year loan term, your monthly payment may be about $150 when you focus on the interest alone. Also, you'll pay about $390 in total interest. With a focus only on the interest rate, the loan looks cheap.
The Annual Percentage Rate (APR) represents the total cost of credit over a year. It includes your interest rate, origination fees, closing costs, and other charges; because it includes many costs, it's often higher than the interest rate.
With the $5,000 loan, you may have to add a 5% origination fee ($250) and $50 in other closing costs to the interest rate. As a result, your APR increases because it includes these extra fees. Since your APR is higher, your monthly payment increases.
This difference is important because if you focus only on the interest rate, you may think you have a cheaper loan that ends up costing you more each month. Also, most lenders aren't as open about APR.
Why Do Lenders Focus on Interest Rate Over APR?
When you need a loan, you'll notice your lender stresses the interest rate more than the APR. Here are reasons why:
Marketing Appeal
Lower interest rates are good for marketing. Most borrowers prefer to see the smallest number in loan terms, and lenders know this.
As a result, they'll always show low interest rates to get you to do business with them. Since APRs include higher fees, they'll bury them in the fine print or tell you about them later in the process.
Payment-Focused Comparisons
Many borrowers compare loans based on the monthly payment rather than the total cost. A loan with lower interest rates but higher fees may appear cheaper on a monthly basis. Lenders know you're likely to focus on short-term affordability, so the interest rate is the best number to emphasize.
Complexity and Confusion
APR calculations are very complicated. Different lenders include different fees, making it hard for you to compare personal loan rates.
Because of the complexity, most lenders will simplify the process by highlighting only interest rates. This approach reduces confusion, making the borrower more likely to agree with the loan terms.
How Do You Compare Loans?
If you want to take out a loan, don't stick with the first lender you find. Here is how you can compare loans:
Shop Around and Pre-Qualify
Since rates and fees vary a lot, don't accept the first offer without shopping around. Take your time to explore flexible personal loan options and weigh them based on APR to get a good deal.
Compare the APR
When you're comparing loans, look at the APR instead of the interest rate. APR shows the true cost of borrowing, including fees. Since APR is your measure, you won't be duped by the low-rate-but-high-fee loan.
Read the Truth in Lending Disclosure
Under the law, lenders must provide you with a Truth in Lending disclosure. This disclosure must state the:
- APR
- Finance charges
- Total cost
Don't sign before going through the disclosure. This document exists precisely to protect you. It'll show you what a loan really costs.
Frequently Asked Questions
What Affects the Rate You're Offered?
The rate you get on your loan depends on several factors. Some of the things that shape your rate include:
- Your credit score
- Your income and debt-to-income ratio
- The loan amount and repayment term you pick
- The lender and type of institution you borrow from
- Whether you're taking a secured or unsecured loan
Getting a lower interest rate allows you to access cheaper loans. You can achieve these lower rates by boosting your credit and comparing offers.
Can the APR and Interest Rate Be the Same?
Yes, it happens when your loan doesn't have any extra fees. You may find lenders who charge no origination fees and other finance charges.
With these lenders, your APR will be the same as your interest rate. However, if you incur additional charges, your APR increases.
Does APR Include All Possible Fees?
No, it doesn't. APR includes many upfront finance charges. However, it excludes costs such as late fees, prepayment penalties, or optional insurance products. Make sure you review the full fee schedule before you sign for a loan.
Should I Refinance If the New Loan Has a Lower Interest Rate but a Similar APR?
Not necessarily. A lower rate looks good. However, if the APR is the same, the fees and closing costs are eating up your savings.
You may pay a lot of money upfront to get that lower rate. Calculate what you'll actually pay over time, not just the monthly payment. If total costs are close, refinancing may not be worth the expense.
Access Affordable Loans
The APR vs. interest rate difference is a lot of money. If you focus only on the interest rate and ignore the APR, you may end up with an expensive loan. Make sure your lender shows you the APR before you sign for the loan.
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