APR vs Interest Rate: Understanding the Crucial Difference

When shopping for loans, you'll encounter two key numbers: the interest rate and the APR (Annual Percentage Rate). While they're related, they serve different purposes and understanding the distinction can save you money.

What Is Interest Rate?

The interest rate is the cost you pay each year to borrow the money, expressed as a percentage of the loan amount. It doesn't include any fees or other charges associated with the loan.

For example, if you borrow $10,000 at a 5% interest rate, you'll pay $500 in interest the first year (assuming simple interest).

What Is APR?

The APR is a broader measure of your loan's cost. It includes:

• The interest rate
• Origination fees
• Points (fees paid to lower your interest rate)
• Broker fees
• Certain other charges the lender may require

APR is designed to give you a more complete picture of the loan's true cost by incorporating these additional expenses into an annualized rate.

When to Use Each

Use the interest rate when:

• Calculating your monthly payment
• Determining how much interest you'll pay over time
• Comparing loans with identical fee structures

Use APR when:

• Comparing loans from different lenders
• Evaluating loans with different fee structures
• Understanding the true cost of borrowing

Limitations of APR

While APR is a valuable tool, it has some limitations:

1. It assumes you'll keep the loan for the full term (early repayment can change the math)
2. It may not include all fees (like late payment fees or prepayment penalties)
3. For adjustable-rate loans, it's based on the initial rate period only

For the most accurate comparison, use our True Cost Loan Calculator which accounts for all these variables and more.