Interest Rate vs. APR: What's the Real Cost of Your Loan?

Interest Rate: The Cost of Borrowing

Every loan comes with an interest rate, which is the cost you pay the lender for borrowing money, expressed as a percentage of the loan amount. This rate determines how much interest accrues on your principal balance over time.

The interest rate is used to calculate your monthly payment. It does not include fees or other charges you may have to pay to get the loan.

Sources: Consumer Financial Protection Bureau, Experian

APR: A Broader Measure of Loan Cost

The annual percentage rate (APR) is a broader measure of the cost of borrowing money. It reflects the interest rate plus certain additional fees and costs, such as origination charges, discount points, and mortgage broker fees. The federal Truth in Lending Act (TILA) requires lenders to disclose the APR on consumer loans so borrowers can compare loan offers more easily.

Because the APR includes most upfront costs, it is typically higher than the interest rate. If a loan has no such fees, the APR may be the same as the interest rate. For installment loans like mortgages, auto loans, and personal loans, the APR includes those fees; for credit cards, the APR and the interest rate are usually the same because card fees are not included.

Sources: Consumer Financial Protection Bureau, Calculator.net, Bank of America, Experian, Discover

What Fees Are Included in APR?

The specific fees included in the APR can vary by loan type and lender, but common items are origination fees, discount points, and mortgage broker fees. These are costs you pay to obtain the loan. The APR does not include everything, though: expenses like late payment fees, property taxes, and homeowner's insurance are generally not part of the APR.

The purpose of the APR is to show the annualized cost of these eligible fees spread over the loan's term. This allows you to compare loans with different fee structures on a more level playing field.

• Common fees included in APR: origination charges, discount points, mortgage broker fees.
• Fees typically not included in APR: late payment fees, property taxes, homeowner's insurance.

Sources: Consumer Financial Protection Bureau, OneMain Financial, Bankrate, Calculator.net

How APR Affects Your Monthly Payment and Total Cost

Your monthly payment is calculated using the interest rate, not the APR. The APR does not directly affect your monthly payment amount. However, the APR gives you a better sense of the total cost of the loan over its full term, because it includes fees that you'll pay over time.

To compare the total cost of two or more loans, you should compare APR to APR, not APR to interest rate. A loan with a slightly higher interest rate but lower fees could have a similar or lower APR than one with a lower rate but high upfront costs. The APR helps you see which loan is truly more expensive over time.

Sources: Bank of America, OneMain Financial, Consumer Financial Protection Bureau

Comparing Interest Rate and APR

When you're shopping for a loan, you'll see both the interest rate and the APR on documents like a mortgage Loan Estimate. In that document, the interest rate appears on page 1 under 'Loan Terms,' and the APR appears on page 3 under 'Comparisons.'

Here's a side-by-side look at how these two metrics differ:

Sources: Consumer Financial Protection Bureau, OneMain Financial, Experian, Bankrate, Bank of America

Why APR Isn't the Same as the Monthly Interest Rate

The APR is an annualized rate that incorporates the loan's fees and interest over the entire term, not a monthly charge. Your monthly interest is still based on the nominal interest rate and your outstanding principal.

Additionally, APR calculations assume you'll keep the loan for its full term. If you pay the loan off early or refinance, the effective cost can be higher than the stated APR, because the fees get spread over a shorter period. For this reason, a loan with lower upfront fees might be more favorable if you plan to pay it off quickly, even if its APR is the same as another option.

Sources: Calculator.net, Investopedia

Using APR to Compare Loan Offers

The APR is a valuable tool for comparing loans because it includes most upfront costs. But it's not the only number you should consider. Since APR excludes some costs and assumes a full-term repayment, you should also look at the interest rate, the loan term, and the specific fees that are included.

If you're comparing two loans and one has a lower APR, that generally means it has lower total costs over the full term. However, if you plan to pay off the loan early, a loan with a higher APR but lower upfront fees might end up costing you less. Always weigh the APR alongside the loan's interest rate and the actual fees you'll pay.

Sources: Consumer Financial Protection Bureau, OneMain Financial, Calculator.net, Investopedia