When shopping for any type of loan, you need to understand the difference between the interest rate on the one hand, and the annual percentage rate or APR on the other. Both of these factors play an important role in the total amount you will pay throughout your loan.
Although these terms are often used interchangeably, there are key differences that separate them. Knowing them will give you a better idea of how much your loan will cost you over time.
Read on to learn the differences between interest rate and APR, which is more important, and where to find fair interest rates for your business loan.
How are the interest rate and the APR different?
The interest rate and the APR are NOT the same. Know what each one consists of:
The interest rate is the amount of interest that your lender charges you for giving you a loan. The interest rate is usually expressed as an annual percentage of the remaining principal balance of your loan.
Interest rates can be variable or fixed:
Variable interest rates change over time. Variable interest rates generally increase as you continue to pay off your loan.
Fixed interest rates, on the other hand, remain static for the entire term of the loan. If you have a fixed interest rate, your monthly payments will be the same throughout the life of the loan.
Variable interest rates are often better if you plan to pay off your loan early because you can take advantage of low introductory rates. Fixed rates are preferred for long-term loans, as they are more predictable and often cheaper in the long run.
Annual Percentage Rate (APR)
The annual percentage rate (APR) represents the total annual cost of borrowing money from your lender. This, in addition to the regular interest explained above, includes fees, closing costs, and any other expenses your lender charges you. In other words, the annual percentage rate or APR is a combination of the fees associated with your loan and the interest on a loan. It is ultimately the total cost of the loan that you will pay annually. This total number is divided equally by the number of payment periods on your loan.
For example, if you take out a loan, your interest rate might be 11%, but your APR might be 11.5%. Your APR is a more accurate number of how much your loan will cost over time.
Interest rate and APR in different financing products
While interest rates and APRs can vary quite a bit, depending on the lender, most financial products have interest rates and APRs within the same range.
In the table below you have the average interest rates and average APRs on some of the most popular financial products: personal loans, business loans, mortgages, and credit cards.
Interest rate and APR on credit cards
In most financial products, the APRs and interest rates are different, as we have just seen. However, on credit cards, the APR and the interest rate are often the same.
Credit card companies generally express their interest rates as APRs. While some credit cards may have annual fees or other charges, these are rarely included in the APR since not all cardholders will incur the same fees.
Should you focus on the interest rate or the APR?
When shopping for a loan, what is more important, the interest rate or the APR?
In almost all cases, you’re better off focusing on comparing the annual percentage rates, or APRs, of different loans.
APRs are there for a reason: to give borrowers an accurate idea of how much their loan will cost over the entire term. APRs make it easy to calculate your monthly payments and the annual cost of the loan.
Remember that the interest rate does not reflect any additional fees. The interest rate can be misleading, as the two loans you are comparing may have the same interest rate but different APRs.
Generally, the only time you should compare interest rates between two or more loans you’re considering is if you plan to negotiate this rate with your lender. The interest rate provides a reference rate, which can be negotiated to reduce it.
Ultimately, lower APR loans will cost you less over time, assuming the principal interest rate is fixed. As such, comparing APR is more useful than comparing interest rates.
How to calculate the interest rate and APR
Do you want to calculate this data yourself? Use these formulas:
Interest Rate Formula
Interest rate = [ Interest paid / ( Principal / time ) ] x 100
APR = [ ( Fees + Interest ) / Principal ] / Number of days on the loan x 36500