APR vs Interest Rate on Personal Loans

When you compare personal loans, you will often see two different numbers. Interest rate and APR. They are similar in appearance. But they tell you different things. If you understand how each works, you will know how to judge offers with confidence.

What is an interest rate?

An interest rate reveals the cost of borrowing the principal only. It is the annual price tag on the money you borrow. If a lender says 12 percent, that means you pay 12 percent a year on the remaining balance. It does not include fees. It is like the sticker price of a bike. You certainly know the basic charge, but not the sales tax or setup charge.

What is APR

APR is the abbreviation for Annual Percentage Rate. This is the interest rate, plus certain required fees such as the origination fee. APR turns the total cost of borrowing into a yearly rate, so that you can compare loans that have different fees and terms. Think of APR as the “out the door” price for that same bike. It wraps in the extras, so you see the true cost.

Why both numbers matter

The interest rate helps you see how quickly interest grows on your balance. The APR shows the true cost of the entire loan. If two loans have the same interest rate, but one has a large fee, then its APR will be greater. If they have different rates and fees, the APR gives them an equal ground for your fair comparison.

If you want real numbers for your budget, check your personal loan options in a few minutes.

A quick example

Suppose you want to borrow $3,000 for 24 months, and you receive two offers.

• Offer A has an interest rate of 12 percent. No origination fees.
• Offer B has an interest rate of 10 percent. An origination fee of 6 percent, which is $180 taken off from the loan at the beginning.

On paper, 10 percent costs less, but the fee raises the APR. However, the fee is deducted from the amount of the loan. So, you get only $2,820 in hand, whereas you are required to pay back on the basis of $3,000.

In many cases, offer A ends up with a lower APR, even though its interest charge is higher. APR reveals that difference.

How term length affects APR

APR is time sensitive. A small loan with a fee can have a high APR because the fee is spread over a shorter number of months. A longer loan spreads the same fee over more months, which will tend to lower the APR. But this does not mean a longer loan is better. You may pay interest for a longer period of time and end up with a higher total cost. Check both the APR and total interest paid over the full loan period.

Watch out for optional add-ons

Some extras do not get counted in calculating APR, like optional extended protection plans. If you choose them, then your real cost increases even though the APR does not. Read the contract and get a list of what is required and what is optional. The goal is to get a clear apples-to-apples comparison.

How to compare two offers

1. Check out the APR first. That tells you the cost per year of the total package.
2. Check the interest rate to see how they derive the cost of monthly interest.
3. Note the term in months. Time will change both APR and total interest.
4. Check the fees. If there is an origination fee, find out if this is a charge against the loan proceeds or added to the top of the loan.
5. Ask to have the payment schedule laid out. You will want the payment amount, the total interest across the term, and the total amount of all payments.

A simple rule of thumb

If two loans have similar terms, usually the loan with the lower APR will cost less overall. If the APRs are close, check the total interest and fees in dollars. Dollars are easy to understand; you can visualize them in your budget. It is like comparing two telephone plans. The yearly cost and the total due tell you more than any catchy label.

Common questions

Does a lower rate always result in a lower APR?

Not always. A low rate and a high fee may cause the APR to be higher than a slightly higher rate and a small or no fee.

Can APR change during the loan?

In a fixed-rate personal loan, the APR is fixed at the beginning. If the loan has a variable rate, the interest portion can change over time. This is explained in your agreement.

Does paying faster affect APR?

APR is not changed after you sign. However, paying faster reduces the total interest amount you will pay. You get finished earlier and at less dollar expense to you.

The bottom line

Consider the interest rate as the velocity of accruing interest, and the APR as the total cost. Use APR to compare loan offers. Use the interest rate to know how the balance grows every month. Look for the fees in the loan, the loan terms, and the total dollars you’ll be paying. Combine these factors to select the loan that fits your budget and gives you no surprises later.