Interest Rate vs. Annual Percentage Rate (APR)
Both interest rate and APR represent the cost of borrowing money. But they aren’t exactly the same
Whenever you’re shopping for credit, the interest rate and the annual percentage rate (APR) are likely to play an important role in your decision. But what’s the difference between interest rate and APR?
Both terms represent the cost of borrowing money. But they aren’t exactly the same thing. And understanding the differences between interest rate and APR can help you make a more informed decision when you’re shopping for credit. Read on to learn more about the two terms, how interest rates and APRs are determined and calculated, and which one you should use when you’re comparison shopping.
What Is an Interest Rate?
An interest rate represents the cost of borrowing money from a lender, according to the Consumer Financial Protection Bureau (CFPB). An interest rate is expressed as a percentage and is charged on the principal loan amount. For a credit card, that loan amount would be the card balance.
What Is APR?
APR is similar to interest rate. But as the CFPB explains, “APR is a broader measure of the cost of borrowing money.” That’s because APR includes not only the interest rate but some other costs too—like lender fees, closing costs and insurance.
Keep in mind that the interest rate and the APR may be the same for a credit card. But that may not be the case with all loans.
Consider a mortgage, for example. As the CFPB explains, when it comes to a mortgage, “The APR reflects the interest rate, any points, mortgage broker fees and other charges that you pay to get the loan. For that reason, your APR is usually higher than your interest rate.”
How Are Interest Rates and APRs Determined?
How interest rates and APRs are determined depends on the type of credit or loan.
When it comes to credit cards, your issuer may decide which interest rate or APR to charge you based on factors like the information in your application and your credit history, according to the CFPB. Generally, the higher your credit scores, the lower your interest rate or APR might be.
That’s true when it comes to loans too. But lenders might take even more factors into account, including things like the down payment and loan term. For example, the higher the down payment, the lower the interest rate or APR might be.
Variable vs. Non-Variable Rates
The interest rate or APR can be either variable or non-variable. A variable rate is often based on an index—like the prime rate—that lenders use to set their own interest rates. And a variable rate could change when the prime rate changes.
A non-variable rate typically stays the same, but it can change under certain circumstances. For example, your non-variable rate could increase if you make late payments or miss payments. But it depends on your lender’s policies and your card or loan terms.
How Are Interest Rates and APRs Calculated?
Lenders use their own formulas to determine how much interest you’ll pay. And how the APR is calculated may depend on the type of credit or loan. Mortgage APRs, for example, include discount points, fees and other charges in their calculations.
For credit cards, the interest can be calculated daily or monthly, depending on the card. “Many issuers calculate the interest you owe daily, based on the average daily balance,” the CFPB explains.
If that’s the case with your card, your issuer might track your balance day by day, adding charges and subtracting payments as they’re made. All those daily balances are added together at the end of the billing cycle. Then, the total is divided by the number of days in the billing cycle to calculate your average daily balance.
The full explanation of how your issuer calculates interest will be disclosed in your card’s terms and conditions. And you can learn more about credit card APRs by checking out this deep dive into how credit card APRs are calculated.
Should You Look at Interest Rates or APRs to Compare Credit Offers?
When you’re comparing credit offers, whether you should look at the interest rates or the APRs depends on the type of credit or loan you’re applying for.
For credit cards, interest rate and APR can be used interchangeably when comparing offers. But pay attention to whether the rate is variable or non-variable, since a variable rate can change.
And keep this in mind from the CFPB: “On most cards, you can avoid paying interest on purchases if you pay your balance in full each month by the due date.”
When it comes to mortgages and other types of loans, comparing APRs may be the most helpful, since APRs include not only the interest but other costs too. And subtracting a mortgage’s interest rate from the APR can give you an idea of how much a lender’s fees will cost you.
When comparing loan offers, it also helps to compare other factors—not just the interest rates or the APRs. Some factors to consider include things like the annual fees, required down payments and loan terms.
Understanding the Differences Between Interest Rate and APR
Remember: Interest rate and APR both represent the cost of borrowing money. And they’re both expressed as a percentage. For credit cards, the interest rate and the APR are usually the same. But when it comes to other loans, the APR can more accurately reflect the cost of borrowing, since it includes the interest rate as well as some other costs.
Now that you know the differences between interest rate and APR, you can make a more informed decision when you’re shopping for credit.
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