Understanding the Difference Between APR vs. Interest Rate
by Fundid on Jun 3, 2022 11:35:13 AM
When searching for a loan, it can be difficult to understand the impact interest has on the amount borrowed. There are many terms used to describe interest, including APR, effective interest, and nominal interest.
Knowing how interest figures into the loan balance is key to understanding how much money you will pay over the lifetime of the loan. This article will discuss APR vs. interest rate and other terms commonly used when describing a loan.
What Does Annual Percentage Rate (APR) Mean?
APR refers to the yearly interest rate that an individual will pay for a loan, including any initial fees. It applies to all types of loans, including credit cards, mortgages, and automobile loans.
In lending documentation, it’s commonly the most visible rate and describes the total amount paid over the year for borrowed money. It will include any fees associated with establishing the loan.
What Does Interest Rate Mean?
An interest rate is the percentage of principal a lender charges to use money. The principal is the total amount borrowed. Interest rates may be fixed or variable.
A fixed rate remains the same during the entire term of a loan, while a variable rate changes following the prime rate. If the prime rate rises, the variable interest rate will also rise.
Conversely, the variable interest rate will decrease if the prime rate decreases. When looking at the annual percentage rate vs. interest rate, remember that the annual percentage rate is the sum of interest and any fees, while the interest rate only includes interest.
How to Calculate APR vs. Interest Rate
What is APR vs. interest rate? APR consists of the total cost of borrowing money, including any upfront fees. Upfront fees will vary depending on the type of loan.
For example, a mortgage will include fees related to the home appraisal, interest, mortgage loan origination fees, transaction fees, and charges to the creditor for purchasing the loan. These costs collectively come to a total APR.
A credit card will typically have fewer fees, but they are still included in the APR. These may consist of a bank processing fee, credit application fee, or transaction fees. When considering interest rate vs. APR, it’s important to understand that APR encompasses interest and transaction or origination fees.
When calculating an APR, add up all interest charges and fees first, then divide that total by the amount borrowed. Multiply that amount by 365. Divide the total by the number of days left in the loan.
To find the interest rate of a loan, you’ll first need to determine whether it is a simple or compounded rate.
A simple interest rate is expressed as a percentage of the borrowed principal amount. For example, if you borrowed $1,000 for a year at 10% interest, you would pay $100 in interest expenses — therefore, you would need to repay $1,100 in total for the loan.
Compound interest is calculated as a percentage of the principal plus any accrued interest. Thus, if your compound interest rate were 1% per month, the amount in interest for the following month would be the prior month's balance and interest expense, charged at an additional 1%.
What Is the Difference Between APR and Interest Rate?
The main difference between APR and interest rate is that APR includes bank charges or loan origination fees when calculating the total cost of borrowing for the year. Interest rate refers only to the interest charged for the loan.
Banks may choose to apply fixed or variable interest rates to their loans, and they may choose simple or compounding methods for the term of the loan.
Understanding the difference between APR and interest rate can help when considering business loan APR rates and business loan interest rates. The business loan APR will include all of the transaction fees associated with the loan and the base interest.
What Is Amortization, and How Does This Relate to APR and Interest Rate?
Amortization refers to the way loan payments are applied to loans. You’ll typically have the highest balance at the beginning of a loan. As you make your monthly payments, a certain amount is applied to interest, and the remaining goes to your outstanding principal. As the principal declines, the amount you pay in interest also decreases.
Only certain types of loans are amortized. These include auto loans, home loans, and personal loans with specific installment terms. For example, a home loan may be paid off over thirty years, while a car loan may have a term of five years.
Loans that don’t have a set repayment schedule, such as credit cards or those that require interest-only payments, are not amortized. An example is a business line of credit.
Amortization relates to APR and interest rate in that it shows the breakdown of interest and fees paid to the creditor each month along with the principal payment.
What Rates Should You Consider When Evaluating a Loan?
While APR represents the simple interest and any charges imposed by the bank for a loan, it does not consider the impacts of compounding interest. Most loans do not charge simple interest — they compound the interest over time.
Consider the effective interest rate to get a more accurate picture of the interest you will pay under a compounding agreement. The effective interest rate includes the impact of compounding.
The more frequently that interest is compounded, the higher the interest paid will be. When faced with a loan that compounds semi-annually or annually at the same rate, the loan that compounds on an annual basis will have a lower effective interest rate.
When reviewing the terms of a loan, you should consider both the base interest rate and its effective rate. Keep in mind that the effective interest rate does not consider the fees and loan origination costs that the APR does.
A Business Example
Depending on the type of loan obtained, the creditor must display specific information related to the cost of the loan in its terms and conditions. The creditor should include the interest rate, the APR, the finance charge, and the amount financed. An effective interest rate should be included if interest compounds over time.
For example, if a loan is obtained to purchase a company vehicle, the lender will need to include the simple interest rate of the loan, the finance charge associated with the loan, and the APR. If interest is compounded, an effective interest rate would also be listed.
If $20,000 is borrowed to purchase a vehicle at an interest rate of 5% and finance charges of $1,000 for five years, the APR would be calculated as 7.029%. $2,777.75 would be paid in interest, and $1,000 would be applied to financing fees.
Are Low APR Rates and Interest Rates Always Good?
Not necessarily. While it's tempting to look at the APR and interest rate and stop there, all loan conditions must be understood. While an interest rate may be low, that does not mean that the bank won’t charge significant origination or transaction fees.
Similarly, if the APR is low, that does not mean that the interest won’t be compounded frequently. Some banks may charge compounded interest daily! This setup can significantly increase the cost of a loan.
What is the difference between an interest rate and APR? Now you know!
When searching for a loan, it's best to have a solid understanding of the different types of interest rates, how APR is calculated, and whether the interest on the loan will compound. Make sure to read through all of the loan conditions before agreeing to it.
Are you evaluating business loan interest rates and APR options? Learn more about Fundid Capital and explore your interest rates and APR for a business loan.