When calculating the cost of debt, interest rate indicates the percentage charged for borrowing money over a given period of time, while annual percentage rate (APR) takes into account yearly interest plus other upfront or recurring loan fees. To help you better understand one of the costs of loans and credit, we've broken down the difference between APR and interest rate.
- What is an Interest Rate?
- What is an Annual Percentage Rate (APR)?
- APR vs. Interest Rate
What is an Interest Rate?
Interest is the rent that a lender charges a borrower on a sum of money. As such, the annual interest rate on a loan or other form of debt is a percentage that describes the yearly cost of borrowing money. Yearly interest rate payments are calculated by multiplying the interest rate percentage by the total outstanding balance of the loan.
For example, on a loan of $10,000 with an annual interest rate of 4%, you'd pay $400 in annual interest during the first year of repaying the loan. On installment loans with fixed payment schedules, interest payments will decrease over time as the balance of the loan is paid off. For this type of loan, like a mortgage, payments are comprised of paying down interest and principal.
What is an APR?
In contrast, APR is an annual rate that includes interest rate payments as well as other fees charged for a loan, which can include origination fees, closing costs and service charges. Because APR is calculated on a yearly basis, it will be higher than the interest rate for loans with frequent payments, short terms, or compounding interest. For example, short-term high interest rate loans will often have a 30% interest rate for a two week term, or $30 owed for every $100 borrowed—which translates into a 782.14% APR.
APR vs. Interest Rate
The difference between an APR and an interest rate is that the APR equals the interest rate plus other loan costs. The APR is more representative of the total annual cost that you'll end up paying for borrowing money. For mortgages, the APR can include the costs of mortgage insurance and any discount points you may have purchased at closing. Because the APR indicates the true cost of borrowing, the government requires that mortgage lenders display APR in their advertisements and on official Loan Estimate and Closing Disclosure documents.
Compared to the APR, interest rate can describe the cost of borrowing money over any period of time - it doesn't have to be a year. In fact, interest rates are often times calculated by month. To find the APR of such a loan, the interest rate is multiplied by 12.
Interest Rate vs. APR for a Mortgage
The APR for a mortgage includes the annual cost of interest plus fees charged at closing. While most lenders charge a few of the same closing costs, like credit report and property appraisal fees, payment structures can vary widely from lender to lender. This means that a mortgage advertised with a low interest rate but high closing costs can end up having a higher APR—and a higher overall cost—than a mortgage for the same amount with a higher advertised interest rate.
Buying discount points is one added cost that increases APR. These points, which are offered by most lenders, cost 1% of the mortgage's total amount and usually decrease the interest rate by 0.25%. While buying down the interest rate can help save money in the long run, some lenders will advertise low interest rates that are dependent on the purchase of points—in a scenario like this, it's important to look at APR. The table below shows the relationship between APR, interest and fees for a $250,000, 30-year fixed-rate mortgage.
|Interest Rate||Monthly Payment||Closing Costs||APR||Total Cost|
For adjustable-rate mortgages (ARMs), the APR disclosed by a lender reflects costs paid during the initial fixed-rate period. If interest rates rise during the adjustable period, then the APR will also rise. In this case, it may be helpful to look at other factors to determine the cost of a mortgage. Accordingly, the most important factor when considering APR, interest rate and cost for a mortgage is the time period which you plan to own your house or pay down your mortgage. If you're planning to sell your house or refinance after a few years, then using APR might not give you a clear idea of mortgage costs.
APR on a Credit Card
For credit cards, interest rate charges are calculated using APR. To assess the rate charged on an unpaid balance, most credit card companies use a method called the "Average Daily Balance." Through this method, a daily periodic interest rate—which is calculated by dividing the APR by 365—is multiplied by the average balance carried for each day of the cycle. The results for each day are added to get the total interest charge. The example below shows how interest would be calculated on a 4 day cycle with a 20% APR, or 0.055% daily periodic rate. (Note that billing cycles are usually around a month.)
|Day||Amount Spent||Daily Balance|
- Average Daily Balance: $250 ÷ 4 Days = $62.50
- Daily Periodic Rate: 20% APR ÷ 365 Days in Year = .055%
- Daily Interest: .055% Daily Rate * $62.50 Average Daily Balance = $0.03
- Interest for 4 Day Cycle: $0.03 Daily Interest * 4 Days = $0.12
Most credit cards have average APRs between 12% and 25% and have a monthly billing cycle. However, interest on credit card debt is charged only on the outstanding balance, and only if that monthly balance isn't paid in full and on time. As such, paying interest on credit card debt can be avoided by paying off the entirety of your balance every month. The example below shows how quickly debt can grow for a credit card with an APR of 20%, monthly spending of $775, and a monthly repayment between $700 and $750.
Nearly every consumer credit card has a variable APR, meaning that the rate charged on the outstanding balance can go up or down depending on the market. When rates you go up, you can end up paying more on your credit card bill if you have an outstanding balance. Credit card companies can also increase your rate to a "penalty APR" of 30% or higher to your balance if you don't pay on time—another reason why it's crucial to pay off your credit card bills on time and in full whenever possible.