The primary difference between an interest rate and annual percentage rate, or APR, is that the APR includes all financing costs on a loan. Comparing the APR on loans is typically the best way to evaluate alternatives, which is why banks are required to disclose the APR when promoting a loan.
Interest Rate Basics
The interest rate on a loan is the amount you pay in interest on your principal balance, expressed on an annual basis. A mortgage at 4.5 percent, for instance, means you pay 4.5 percent interest per year on your mortgage balance. As you pay off the loan, the amount of interest decreases because the percentage of a lower principal balance is naturally less than it was the month before.
Because APR stands for "annual percentage rate," some borrowers get confused and assume APR is annual and interest rate is not. In fact, APR just refers to the entire financing charges on a loan, expressed on an annual basis. The APR takes into account upfront closing costs or loan fees you pay to get the funds. On a home loan, for instance, you might pay $2,000 to $5,000, or even more, based on the value of your property.
When you add the finance charges to the ongoing interest expenses, you get a truer depiction of the costs of financing. If two loans of equal amounts have the same interest rate, the one with the lower upfront charge would have the lower APR. Unless you pay no extra costs to get a loan, the APR is always higher than the interest rate, according to the Consumer Financial Protection Bureau. By comparing APR offers from two lenders, you know which one has the best value over the life of the loan.
Understanding the True APR
In most cases, the lowest APR signifies your best value as a borrower. However, Lending Tree points out that you have to consider the actual life of the loan and not just the repayment period. On a five-year car loan, an APR of 4.7 percent is better than an APR of 4.9 percent, assuming you pay the loan off in five years. However, if the borrower pays off the loan in one or two years, the "real" APR is affected by the shorter repayment period. If the 4.7 percent loan has a much higher upfront finance cost than the loan with a 4.9 percent APR, that closing cost weighs more heavily when spread over one or two years rather than five. It is possible the "real" APR is higher on the loan quoted at 4.7 percent if it is paid off early. If you don't intend to hold the loan for the entire repayment period, give greater weight to the upfront fees relative to the interest rates on the loan.