APR vs. interest rate, explained

It’s crucial that borrowers understand the difference between APR and interest rate to ensure they are fully aware of what potential charges they may incur.

In this article, learn the difference between APR and interest rate, explore how APR and interest rates are calculated, and how they affect the total amount repayable.

What is APR?

APR is the total cost of borrowing for a year. It includes interest rates and other fees that must be paid, such as standard fees or insurance. APR is shown as a percentage and may help borrowers compare the total cost of loans or credit cards from different lenders.

When looking at borrowing money, it’s common to see a representative APR. This is not necessarily the rate that a borrower will receive once the credit application is made. It is important that borrowers are clear on what the actual APR will be as it could be significantly higher than the representative APR. Borrowers should confirm the APR before agreeing to borrow money. The APR is generally shown when the borrower receives a loan or credit card term agreement.

Lenders calculate APR based on a borrower’s individual circumstances. They typically take into account an applicant’s credit history and financial situation. If the borrower is making a down payment, this may also be considered and could potentially lead to a lower APR. Calculations and factors may vary depending on lender, borrower, and type of credit applied for.

APR for loans, specifically, is calculated using several factors, including:

• Loan amount
• Interest payable
• Schedule of loan payments (term of borrowing, i.e., 4 years)
• Additional fees such as late payment fees, broker fees, or insurance fees

For example, if a borrower took out a loan for $1,000 with a 5% interest rate and $50 in additional fees for one year, the APR would be calculated using:

Loan amount: $1,000

Interest: $50 (5% of $1,000)

Schedule of loan payments: 12 months

In this example, the APR for the loan would be 10% and the total cost of the loan would be $1,100.

Credit card APR is based on the interest the borrower will pay if they have a balance on their credit card, as well as any standard fees that apply. If the balance is paid in full at the end of the statement period, the APR and interest rate will not be applied. But if a borrower spent $500 on their credit card in June and didn’t clear the balance until September, they would be charged APR and interest.

It is important to note that different credit cards may offer different APRs for spending, cash withdrawals, or balance transfers.

What is an interest rate?

The interest rate is the amount it will cost to borrow money. In precise terms, it is the fee that is added to the amount of money borrowed each month. Credit card interest rates and loan interest rates are shown as a percentage. Most types of borrowing include an interest rate except for interest-free loans or interest-free credit cards².

Loans will often use fixed interest rates, meaning the interest rate remains the same over the course of the loan. Credit cards generally come with variable rates. A variable rate means the interest rate is tied to the prime rate set by the Federal Reserve. Credit card holders can review their statements and terms to determine the exact rate for a given statement period.

It is important to understand the interest rate, as the higher the interest rate the higher the total cost of borrowing will be.

The interest rate for a loan may be calculated using the following factors:

• Loan amount
• Schedule of loan payments
• A borrower’s credit history, financial circumstances, and other factors

With the same example used for calculating APR, if a borrower took out a loan for $1,000 with a 5% interest rate for one year, the interest rate would be calculated using the formula below:

Loan amount: $1,000

Interest rate: 5%

Schedule of loan payments: 12 months

This would make the amount of interest $50. The total repayable amount would then be $1,050. However, this does not consider any fees and therefore may not accurately show the total cost of borrowing.

Interest rate on credit cards works slightly different. Credit card interest only applies if the balance isn’t paid in full at the end of a statement period. For example, if a borrower has $200 on their credit card balance and makes a full $200 payment before their statement period ends, there would be no interest applied. However, if the borrower only paid $50 at the end of the statement period, interest would be applied to the remaining $150 balance.

The amount of interest applied depends on the interest rate the individual was given when taking out the credit card or the current variable rate. If the interest rate is 20%, then the amount of interest on the $150 balance would be $30, giving a new balance total of $180.

If a loan or credit card is interest-free, it means there is no interest to pay. It is important to remember that this may only be for a promotional period. Borrowers should be clear on the interest-free terms before applying for and accepting a credit offer. They should also check if an interest-free credit card’s offer applies to the entire credit balance or just balance transfers.

Differences between APR and interest rate

So, what is the difference between APR and interest rate? The main difference is that the interest rate shows the cost of borrowing but does not factor in additional fees. APR includes interest and fees, so it may give a more accurate total cost of borrowing³. Let’s take a closer look at the difference between APR and interest rates:

• APR may give a clearer view of the total cost of borrowing as it incorporates all costs, including fees unrelated to interest.
• Interest rate may be less clear as it does not include all associated costs that are charged.
• Low interest rates do not necessarily mean a lower cost of borrowing. If the loan incurs high fees, this will increase the APR which could result in a higher total cost.

When to use APR vs interest rate

While evaluating credit options and borrowing terms, some may wonder if APR or interest rate is more important. But it is essential that borrowers take both APR and interest rate into account when comparing borrowing options to get a full view of all costs.

Rather than looking at the APR or interest rate individually, borrowers should look at both to get a complete view of the total borrowing cost. Some lenders may offer a low interest rate to attract customers but have a high APR which may push the total cost much higher.

Consider the following when assessing borrowing options and evaluating APR and interest rate:

• Borrowers should understand how much they need to borrow. It’s important to borrow only how much one needs and to avoid stretching finances with monthly repayments that don’t fit into one’s budget.
• Credit scores may impact the APR and interest rates borrowers are offered, so it may be good practice to check credit scores before applying.
• Compare offers from different lenders. The rates borrowers receive may vary between different lenders, types of credit, and borrowed amounts.
• Compare interest rates and understand how they will affect the monthly payment and the amount repayable. Be clear whether the interest rate is fixed or variable. Variable rates may lead to potentially higher payments than expected if rates were to change.
• Evaluate and compare APRs to get a full total cost of borrowing that includes all fees.
• Review all terms and conditions before submitting an application or agreeing to borrowing.
• Borrows could seek professional financial advice to help them make the right decision for their circumstances.

When borrowing money, APR and interest rate are key factors to consider. While some lenders may offer low interest rates that may make a credit card or loan more appealing, a high APR could offset that benefit. It’s important to consider both APR and interest rate to encapsulate a full view of the cost of borrowing.

Knowing the difference between these — and how they work to represent added costs — may help borrowers better evaluate credit and borrowing offers and potentially make more informed borrowing decisions. Before applying for or agreeing to credit and borrowing terms, be sure to evaluate all factors. It’s imperative to ensure any required payments fall into one’s budget, to only borrow as much as one needs, and to only spend within one’s means.