APR Vs Interest Rate: What Is The Difference?

An interest rate is the price of the money you borrow. APR is that price plus the fees and charges attached to the deal, expressed as one yearly percentage. Two loans can carry the same headline rate and very different APRs, which is why comparing rates alone can lead you to the more expensive option.

What Each One Measures

The interest rate is applied to the outstanding balance to produce the interest you are charged each period. A 6 percent annual rate on a 20,000 balance costs 1,200 a year if the balance stays at 20,000, or 100 a month on a simple monthly basis.

APR includes that interest plus mandatory fees, such as arrangement fees, broker fees, closing costs on a mortgage or the annual fee on a card where it applies. Because those costs are spread across the year and expressed as a percentage, APR shows what the borrowing costs you in total over twelve months.

A loan of 20,000 with a 6 percent rate and a 600 arrangement fee has an APR above 6 percent, because the 600 is a real cost of getting the money. The rate tells you what you pay for the balance; the APR tells you what the deal costs.

Calculating The Difference

Take a 10,000 loan repaid over five years. At 7 percent simple interest with no fees, total interest is roughly 1,870 and the APR is about 7 percent. Add a 400 arrangement fee and the effective cost rises: the fee is 4 percent of the amount borrowed, spread over five years, adding roughly 0.8 percentage points a year to the true cost.

Short terms magnify fees. The same 400 fee on a two-year 10,000 loan adds about 2 percentage points a year, because the same fixed cost is spread over fewer months. A fee that looks small in pounds is a large percentage when the loan is short.

For credit cards the same logic applies but the numbers shift monthly. A card at 22 percent APR with a 3 percent balance transfer fee charges you the fee up front and the interest on the transferred balance. Those two components together are what the APR figure is meant to represent.

Where The Two Diverge

Cards usually quote an APR that already includes the interest, and often a separate APR for purchases and for cash advances. Cash advance APRs are typically far higher, and interest on advances often starts from the transaction date rather than the statement date.

Mortgages quote both a rate, which sets the monthly payment, and an APR, which includes fees. A deal with the lowest rate can carry the higher APR once fees are counted, which is why quoted comparison tables often use APR rather than rate.

Promotional rates are the biggest source of confusion. A card advertising zero percent for twelve months has an APR that becomes the standard rate after the period ends. The zero applies to interest, not to the fee for a balance transfer, and not to the standard rate that resumes later.

• Nominal or headline rate - The rate used to calculate the interest charge on the balance.
• APR - Rate plus compulsory fees, expressed as one yearly percentage. The better comparison number.
• Effective annual rate - Takes compounding into account. Higher than the nominal rate when interest compounds more than once a year.
• Representative APR - An advertised example APR. Not everyone is offered it; a given share of applicants must receive it or less.
• Default or penalty rate - A higher rate that applies after missed payments. Check what triggers it and what rate applies.

How To Compare Two Offers

Compare APRs when the fees differ, because that is the figure designed to absorb them. Compare rates only when the fee structure is identical or when all fees are zero.

Then convert the APR to a monthly figure by dividing by 12 to see the actual cost per month. A 24 percent APR is 2 percent a month, meaning a 3,000 balance costs roughly 60 a month in interest alone before any principal is repaid.

Finally, model the total cost over the period you will actually hold the debt, not the advertised term. A low APR with a long term can cost more in total than a higher APR cleared in two years. Multiply the payment by the number of payments and subtract the amount borrowed to get the true cost in money.

This article is educational only and is not financial advice. Figures vary by country and lender, so check the rules that apply where you live.