What is the Difference Between Interest Rate and APR?

wiseGEEK Writer

Interest rate and APR (annual percentage rate) are two ways of evaluating and comparing loans. The concept of interest rate is fairly easy to understand. This is simply the amount of interest charged per year on the loan. So a 5% interest rate simply means that each year a borrower will pay 5% interest. The APR is a bit more complex and refers to the interest plus the upfront fees charged to the loan, in addition things like mortgage protection, which are tabulated into the loan over the lifetime of it. Some people call this the actual percentage rate because it reflects some of the common fees associated with getting a loan, but the matter is a little more complicated.

The APR offered by a credit card will depend on the individual credit user's history.
The APR offered by a credit card will depend on the individual credit user's history.

When evaluating interest rate and APR, many people are told to look at the APR as the best way to compare loans. This can make good sense in some instances because two different APR rates with an identical interest rate may say a lot about the fees that are attached to the loans. On the other hand, financial experts are quick to observe that most people obtaining loans don’t always plan to keep them forever. Since the APR spreads the fees charged over the life of the loan, it may not accurately represent what kind of fees the lender is out of pocket if he changes loans. The upfront fees don’t tend to go away if a person changes to a new loan, and they could be removed from total equity, or a new loan would have to pay those fees.

The length of the loan has varying effects on interest rate and APR. Interest rate, provided it is fixed, doesn’t change. It remains the same whether the loan is for 20 or 40 years. APR does change. It’s easier to hide the fees in longer loans so that the APR doesn’t seem that much higher than the interest rate. Again it has to be noted that the fees included in the APR are considered paid upfront, so what may appear to be a good deal on a mortgage of long length, needs to be considered more carefully. An actual comparison of upfront fees may be of more use than a comparison of interest rate and APR.

It is also important to note that APR doesn’t reflect all the fees charged. It doesn’t reflect late payment charges, and it’s vital to find out what fees a lending institution has a right to exclude when calculating the APR. Still, even if this calculation is imperfect, it’s generally a better basis for comparison than interest rates alone. Such a comparison should be followed by further scrutiny before determining the most attractive lending offer.

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