When shopping for a mortgage, it can be tough to make an accurate comparison. Understanding the difference between a loan’s interest rate and annual percentage rate (APR) can help you become a more informed mortgage shopper, potentially saving you money in the process.

The annual percentage rate (APR) and interest rate on a mortgage, both expressed as percentages, serve as benchmarks against which to compare different loans and their expenses. The main distinction is that the interest rate will always be lower than the APR.

Consider a $300,000 30-year fixed-rate mortgage at 7% interest, with a 1% origination charge ($3,000) and one mortgage point ($3,000), totaling $6,000 in costs. That additional expense raises the APR to 7.197 percent.

What is an Interest Rate?

To comprehend APR vs. interest rate, first grasp a simple interest rate. The interest rate on a loan shows how much you’ll pay over time to borrow money. There’s nothing else. There are no origination, closing, or paperwork fees, or other loan-related charges involved. Assume you’re shopping for a personal loan and the stated rate is 4.99%. The first question you should ask yourself is whether the rate on the personal loan includes any additional expenses.

Looking at interest rates can be similar to ordering a hamburger only to discover that the bun, ketchup, mustard, onions, and pickles are not included in the advertised price. The total cost of the burger is a separate figure entirely.

That is why it is critical to compare interest rates and APRs. The annual percentage rate represents the overall cost of a loan.

Investigating a lender’s interest costs is a vital first step in comparing APR to interest rate. Lenders can set their own interest rates and costs within legal restrictions. And, because various borrowers receive varying rates, your interest rate may differ from a lender’s quoted rate.

The interest rates mentioned online are reserved for those with the best credit scores. If that’s not you, the rate you’re offered will be depending on a variety of factors:

• Credit score
• Loan amount
• Debt-to-income ratio
• Upfront fees (generally paid to keep the rate low)
• Down payment amount
• Length of the loan (generally, shorter terms have lower rates)
• The type of credit you apply for

That last point is especially important. For example, a credit card normally carries a higher interest rate. Mortgage and auto loan interest rates tend to be lower.

How interest rates determine your monthly payment

The interest rate is a major factor in setting your monthly payment. This is how it works.

Assume you wish to borrow $30,000 for a new automobile loan. The interest rate for Bank A is 6.75%. If you get a five-year loan, your monthly payment will be $590.50. You investigate and discover that Bank B has a 6% interest rate, resulting in a monthly payment of $579.98.

Your monthly payment is calculated using the interest rate on your promissory note, not the APR. Bank A’s slightly higher interest rate results in a monthly payment that is $10.52 greater than that of Bank B. It may not seem like much, but over the life of the loan, the difference comes to $631.20, which is enough to buy a set of tires or have your oil changed ten times.

To save money, examine the interest rates of numerous lenders before signing on the dotted line. However, keep in mind that you’ll need to examine the whole cost of the loans, which includes more than just the monthly payment, by comparing the APR to the interest rate.

What is APR?

Knowing the difference between APR and interest rate is useful for determining the “real” cost of a loan. The annual percentage rate (APR) of a loan comprises all of the fees associated with borrowing money. Unlike a stripped-down, bare-bones interest rate, APR exposes the total cost of the loan stated as a percentage. It illustrates the whole cost of borrowing money, including all of the extras you’ll have to pay in addition to the standard interest.

The fees associated with your loan (and reflected in your APR) vary depending on the sort of loan you’ve applied for. Here’s an example of the costs you should anticipate to find in your APR:

• Application fee: The fee some lenders charge to apply for a loan.
• Origination fee: An upfront fee designed to compensate the lender for putting a loan together. The stated interest rate does not include this fee, while APR does.
• Underwriting fee: A fee charged for the underwriter who reviews your application and decides whether to grant credit.
• Document fee: Lenders often bake this fee into the loan to cover the effort it takes to draw up the documents you’ll sign. It’s yet another cost that becomes part of interest rate vs. APR.
• Dealer prep: Auto dealers normally slip this fee into their APR, saying they’ve earned the extra money for preparing a vehicle for sale.
• Processing fee: A general term for any extra fees a lender hopes you’ll pay. Many are negotiable.

APR vs. interest rate applies to all types of loans. Unless a lender specifically indicates that a rate is the APR, you must ask what the APR will be.

At the turn of the twentieth century, banks could charge any interest rate they pleased. Without rules in place, they frequently earned 10% to 500% per year on mortgages and private loans. Americans in need of a home loan had to deal with mortgage lenders that operated more like loan sharks than bankers. APR vs. interest rate was obviously not disclosed upfront.

Congress passed the Truth in Lending Act (TILA) in 1968, and one of its provisions served to clarify the distinction between APR and interest rates. Lenders are now required to provide consumers with a complete picture of how much a loan will cost, including fees.

Read Also: 10 Benefits of Using a Secured Credit Card

Both interest rate and APR tell you important things about a loan. Comparing the APR of a loan to its interest rate is very helpful for several reasons.

• It allows you to compare apples to apples. All lenders must follow the same rules when calculating APR (with a couple of variations — we’ll touch on that topic in a moment). You have a better sense of the true cost of a loan with APR and you can compare it to other loans.
• You know how much a loan will cost at a glance. Without a stated APR, it’s a matter of working through individual fees and adding them to the interest rate. That’s time consuming.
• You can see how much you’ll pay in fees. Compare the APR vs. interest rate. The closer the two numbers are, the fewer fees are built in.

The interest rate and annual percentage rate (APR) both indicate the expenses you will pay for a loan. The APR, however, incorporates all lender fees, making it more relevant in general. However, you’ll want to compare both. For example, if you want to know your monthly payment, you should look at the interest rate, not your loan’s APR. This is because many of the expenses included in the APR are paid in advance rather than on a monthly basis.

What Is A Good Credit Card APR?

The APR provided when opening a credit card is determined not just by an applicant’s credit score or credit report, but also by the United States Prime Rate. Major financial organizations utilize the Prime Rate to determine lending interest rates. To calculate credit card interest rates and accompanying APRs, lenders begin with the Prime Rate and add additional margins in the form of interest to reduce the risk of default and profit from outstanding balances.

As of January 2024, the current federal prime rate in the United States (reported by the Federal Reserve as the “bank prime loan”) is 8.5%. For consumers with good credit, a new account may have an APR based on the current Prime Rate (8.5%) plus a lender’s margin of 10%, for a total of 18.5%. In contrast, a borrower with low credit may pose a higher risk and so earn an APR that includes a lender’s margin of 20%, resulting in a high APR of 28.5%.

To calculate an APR, lenders consider a borrower’s creditworthiness and the Prime Rate, as well as their payment history, credit report, and debt-to-income ratio (DTI). Credit cards with incentives such as points, miles, or cash back on purchases typically have higher APRs than non-rewards cards.

In general, the cardholder benefits more from a lower APR. Though we advise against holding a credit card balance, advancing cash, or engaging in any other activity that incurs interest fees, a relatively “good” APR can mitigate the impact in the event of the unexpected. An APR that is lower than the national average is deemed “good”.

Cardholders who want to make a major purchase and want to carry a balance for a short period of time may look into a credit card with a 0% introductory APR. Cards with 0% promotional rates allow you to pay off invoices without incurring any interest costs. Keep in mind that after the promotional term, the APR will revert to a variable rate dependent on creditworthiness, so only do this if you are certain about your plans.

On the opposite end of the scale are credit cards with abnormally high APRs targeted to users with low credit ratings who would otherwise struggle to obtain a credit card. It is fairly uncommon for these cards to have a variable APR over 25%. These items are marketed as useful for trying to develop credit, and some people may view them as their only option.

How To Qualify for a Good APR

While several factors are considered to calculate APR, the first thing any lender wants to know is if the applicant has completed payments on past accounts on time. Payment history accounts for 35% of a credit score and is still the most crucial component when a lender analyzes overall creditworthiness. Lenders are more inclined to offer a lower APR to people who have a long track record of paying payments on time.

An applicant’s credit utilization ratio also accounts for a significant amount (30%) of their credit score. The credit utilization ratio is computed by dividing the entire balance outstanding by the total credit limit. A decent credit utilization ratio is typically less than 30% for each individual card and across all accounts. Staying within this utilization limit and reliably paying off balances are some of the best ways to qualify for a lower APR.

One smart way to get a good APR on a credit card is to apply for one with an introductory or promotional deal. Banks will commonly offer 0% introductory APRs on purchases and balance transfers for periods ranging from six months to nearly two years. A credit card with a 0% APR introductory rate is a feasible alternative for consumers wishing to finance a significant purchase or pay off debt from a high-interest credit card. Be aware that once the 0% promotional period expires, the APR will return to the card’s usual variable rate.

Cardholders may also try to negotiate a lower APR directly with a bank. If they can demonstrate that they make timely payments and that their credit score has improved over their tenure as a customer, they may be able to convince the bank to consider a reduced interest rate—just asking doesn’t hurt. Cardholders should highlight any other cards they have been preapproved for with lower APRs to provide an additional incentive to the bank, which is likely looking to retain consumers.

There are tactics to consider while engaging into an agreement. Although a consumer may be enticed to buy at the lowest price, this is not always the best option. Consider a homebuyer considering whether to reduce their interest rate or their annual percentage rate (APR).

By chasing the lowest interest rate, the borrower may be able to achieve lower monthly payments. Consider a scenario in which a lender has the option of charging 5% or 4% with two discount points (about 2%). In this situation, a higher interest rate could be beneficial.

Interest Rate

• Narrower look at what you pay when you borrow money
• Does not include other fees connected with your loan
• Determined using client’s individual data (i.e., leverages credit score)
• May be more favorable if you aren’t planning on staying in your home longer-term (due to breakeven point for fees)
• Lower rates often translate to lower monthly payments, though the total loan may still be more expensive

APR

• Broader look at what you pay when you borrow money
• Includes points, origination fees, broker fees, and closing costs
• Mainly controlled by the lender (i.e., includes discount points and broker fees)
• May be more favorable if you are planning on staying in your home longer-term (due to APR assumptions over the entire term)
• Lower APR often translates to a lower total loan cost, though the monthly payments may be higher

Final Words

Understanding how APRs work is critical to developing a comprehensive picture of your card alternatives and the best methods for building and maintaining credit. The more knowledge you have as a consumer, the better you will be able to compare different credit card offers and determine which is ideal for your financial circumstances. APRs are only one factor in making smart credit card decisions, but they can have a significant impact on financial management.