What’s the Difference Between Interest and APR?
So, what is the difference between interest rate and APR? And which one is more important? If you use credit products, you´ll want to understand these terms so that you can make informed decisions.
What’s the Difference Between Interest Rate and APR?
Interest is relatively straightforward. It’s what you pay on principal — in other words, the total amount borrowed. For example, let’s say you buy a sofa for $1,100. You charge the furniture on your credit card. In this case, $1,100 is the principal. For the privilege of using the bank’s money to purchase the sofa, you’ll pay interest on the principal amount of $1,100.
APR, on the other hand, is the aforementioned interest rate plus any fees you may incur. Although your credit card company may charge fees, these are not the type of fees that are included in APR. You could, for instance, pay an annual fee of $75 or incur a $35 penalty for going over your limit. None of this is included.
So, which fees are included in APR? Suppose you buy a new house and finance $200,000 on a 30-year mortgage at an interest rate of 4.25 percent. When you purchase your house, there are several fees added on. They may include, for example, discount points, origination charges, and any other fees that are paid out over the term of the loan. These charges are added to the amount that you borrow to purchase the home. If those fees are $6,000, your APR is 4.50 percent. This is the actual interest that you will pay over the next 30 years.
Interest vs. APR on Loans
As mentioned, credit cards don’t have fees that are calculated in APR. Personal loans, however, do. Typically, these fees range between 1 to 8 percent, depending on your credit rating and loan term, among other things. With fees, a personal loan APR is higher than the interest rate.
Here’s a comparison between two banks, both offering a $10,000 loan at 9% interest:
- Loan amount: $10,000
- Term: 3 years
- Fees: 3% upfront ($300)
- Monthly payment: $318
- Interest rate: 9%
- APR: 11.10%
- Loan amount: $10,000
- Term: 5 years
- Fees: 5% included in the loan ($500)
- Monthly payment: $218
- Interest rate: 9%
- APR: 11.11%
The two loans have nearly identical APRs. Bank B has a lower monthly payment and, although the loan origination fee is higher, it’s included in the principal amount. So when you borrow $10,000 from Bank B, you´ll receive $10,000. Bank A charges the fee upfront, which has the net effect of reducing the initial amount of cash remaining. Which one is better? Well, with Bank B you´ll pay more than double the interest: $3018 vs. $1,448. Plus you´ll be in debt for two additional years.
Where to Find APR on Existing Debt
If you don’t know what APR you’re paying, look for it on your statement. Or call your bank or mortgage company. It’s easy to find the APR on your credit card statement. By law, it’s in large 18-point font enclosed within a border known as the Schumer box. But be aware that the Schumer box doesn’t tell the whole story. If you see an asterisk, your interest rate will vary according to prime. Not to go too far into the weeds, but the prime rate is simply the rate charged to the most creditworthy customers and is based on the federal funds rate.
Credit is complicated. Even though the Schumer box is intended to clarify things, it can still be confusing. Depending on the type of credit card, there may be three scores or a range shown there. In this case, your APR depends on your credit rating:
- Excellent: 800 to 850
- Good: 670 to 799
- Fair: 580 to 699
If your score is excellent, you should get the best APR. If your score is below 580 to 699, you´ll incur the highest rate shown. There will likely be several categories of APR shown, including a low or 0% introductory rate. The cash advance and penalty rates are the highest. Your purchase rate is what you typically pay on your day-to-day expenditures.
Know Your Interest Rates
Always look at the APR on the credit products you use. Remember:
- Not all lenders handle fees the same way.
- Ask for the information you need to make a valid comparison.
- Use your knowledge of APR and credit scores to negotiate the best rates.
Your best APR is 0%. But if you can’t get that, pay off your credit cards in full each month. It’s one of the best ways to protect your credit rating and keep your financial plan on track.
Another way to stay on top of your credit rating is to use a credit monitoring service like SmartCredit.com. With SmartCredit, you’ll have more control over your borrowing options and future score.