Understanding the difference between APR (Annual Percentage Rate) and the interest rate is essential for borrowers to comprehend the true cost of a loan. Below is a detailed comparison of the two, including an example for clarity:
The interest rate of a loan is the cost you pay each year to borrow money, expressed as a percentage of the loan amount. It is the 'base rate' that determines the interest expenses on your loan and does not include other costs or fees involved in the procurement of the loan.
The Annual Percentage Rate (APR) encompasses the total cost of borrowing. It includes the interest rate as well as other costs or fees involved in obtaining the loan (such as origination fees, closing costs, insurance, and discount points). The APR is expressed as a percentage and provides a comprehensive view of the cost of the loan.
Suppose you are considering a $100,000 loan with a 4% interest rate and a 5% APR. The interest rate tells you that you'll be paying 4% of the loan amount ($4,000) annually in interest. However, the APR indicates that when you factor in other fees and costs, the annual cost of the loan is effectively 5% of the loan amount ($5,000). This means the true cost of borrowing is higher than what the interest rate alone would suggest.
| Cost Component | Included in Interest Rate | Included in APR |
|---|---|---|
| Base Interest | Yes | Yes |
| Origination Fees | No | Yes |
| Closing Costs | No | Yes |
| Discount Points | No | Yes |
| Broker Fees | No | Yes |
| Other Financing Costs | No | Yes |
Note: In some cases, a loan with a lower interest rate might have a higher APR due to the inclusion of fees and other costs. This is why it's crucial to consider both the interest rate and the APR when evaluating loan offers.