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Personal Loan APR vs Interest Rate: Why You Need to Know the Difference
When it comes to understanding the total cost of taking out a personal loan, it’s important to ensure you know what you’re getting into (and how much it will cost you to get out of it). Yet when we talk about the cost of lending, it’s usually discussed in one of two terms that are often used interchangeably: annual percentage rate (APR) or interest rate.
Yet the truth is that while either the APR or the interest rate of a loan may be presented upfront to potential borrowers, they’re not the same thing. In fact, the interest rate on a personal loan may be much different than the APR, and this means any borrower needs to understand this difference well before you sign on the dotted line.
What Is an Interest Rate?
“Interest is interest”, you might be thinking. “Why do we need to know the difference?” There’s a very good reason for that — the interest rate, which is what is usually advertised when you go loan shopping, is used to calculate the interest expense on your loan. In other words, it’s the fee you’ll pay, in addition to the balance of the loan, for the privilege of receiving the loan in the first place.
Interest rates can change over time. The Federal Reserve often exerts an influence on overall rates whenever they alter the federal funds rate, which is the base interest rate banks use in lending reserve balances to one another overnight. The Fed usually reduces this rate in recessions to entice consumers to spend money, for example, while in boom markets the Fed will jack up the rate to encourage savings. While it’s not always a factor when it comes to interest rates on personal lending, it does have a major influence on the market conditions as a whole.
What’s an APR?
Your loan’s interest rate is how much interest your lender is charging you for taking out the loan. However, that’s not always the big picture when it comes to total cost. This is where the annual percentage rate comes in. In fact, it’s just about universally true that examining the APR of your loan is going to be a much better way to measure how much your lending is going to cost overall. The reason for this is because the APR takes into account not just the expense of interest but also any other costs and fees that come along with the loan.
What types of other costs are we talking about? There are quite possibly dozens, depending on the circumstances of your specific lender. Closing costs, broker and origination fees, discount points, rebates, and more can alter the cost of a loan, and the APR takes all these different cost changes into account. In just about every case (except where you’re getting a possible rebate on some of your interest expenses), the APR of a loan is greater than or equal to the interest rate.
So Which One Should You Rely On?
At this point, it’s obviously clear that you can’t just look at interest rates when shopping for personal lending. Consider a situation where you have to choose from two different lenders that are offering you a loan with the same interest rate. In this case, if these two lenders are listing different APRs on their loans, you can clearly choose the lender who is offering a lower APR, as this means you’ll pay less in upfront or “hidden” fees.
At the same time, though, you can’t always rely on APR to tell the whole story. There are a few warnings that you’ll need to heed. When a lender includes their servicing costs in the APR, these don’t always come upfront but are spread out across the entirety of the loan. In the case of a large personal loan or a mortgage, this can be spread over decades — and this can lead to it being more expensive to refinance or sell a home as a result.
Additionally, the APR is not as useful in determining cost when you have adjustable-rate lending, as there’s no way to know how interest rates may change in the future.
The Last Word on APR Versus Interest Rate
It’s true that the interest rate of your loan will show you the cost associated with repaying that loan. At the same time, however, the APR will provide a better picture of the cost of your loan, as it takes into account all the fees that accompany applying for a loan, processing that loan, closing costs, and any other fees. This makes it crucial to always check both the APR and the interest rate whenever you’re considering applying for a personal loan. This way, you’ll be sure to be getting the best deal, and all without running into any nasty surprises down the line!