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The terms “interest rate” and “annual percentage rate” (APR) are easily confused. Understanding the difference between interest rate and APR — and what they do and don’t tell you about the total cost of repaying your loan — can save you a lot of money.

APR vs. interest rate

The term borrowers are usually more familiar with is interest rate. This is the rate that your lender uses to determine your interest payments. The interest rate, which typically depends on your credit history and loan repayment term, is applied to your outstanding loan principal.

Taken together, your interest rate and the length of your repayment term determine your monthly payments. So, if you take 10 years to pay off a loan, your monthly payments will be lower than if you take five years. While the interest rate and monthly payment can give you an idea of how much your loan will cost to repay, it doesn’t tell you the whole story.

In addition to paying interest on your loan, you may be charged origination fees and other expenses when you take your loan out. The annual percentage rate (APR) is a calculation that lenders are required to make under the Truth in Lending Act to help you understand the impact of these additional fees and expenses.  

In general, the more fees and expenses are heaped onto a loan, the higher the APR. If a loan has no additional fees, the interest rate and APR will be the same (unless you are choosing to defer payments, in which case the APR may be lower than the interest rate — more on that below).

The APR is sometimes called the effective interest rate, because what it essentially shows is the interest rate on the money that you actually received, after you’ve paid fees and costs.

If you take out a $10,000 loan at 5 percent interest with a $500 upfront origination fee, you only receive $9,500. But your interest charges are still based on an initial loan balance of $10,000. So while your interest rate is 5 percent, your effective interest rate on the $9,500 you actually received is 5.43 percent (assuming a 10-year repayment term).

The larger the loan, the less of an impact fees and costs have on APR. That $500 fee would only increase the APR on a 10-year $100,000 loan with a 5 percent interest rate to about 5.044 percent, compared to the 5.43 percent APR on a $10,000 loan with the same fee.

The same is true of the loan repayment term — the longer you are spreading your payments out, the less impact fees and costs have on APR. Spread that $500 fee on a $10,000 loan with a 5 percent interest rate out over 30 years, and the APR is 5.26 percent, compared to 5.43 percent if repaid over 10 years.

APR and student loans

What does all of this mean in the real world?

Remember, the APR is just a calculation that’s designed to help you understand the impact of loan fees and costs. Not all loans carry fees, but “no-fee” loans may carry higher interest rates than loans that do charge fees. The APR can help you compare loans that don’t carry fees (“no-fee” loans) with loans that do.

If you’re buying a home, for instance, mortgage lenders may let you “buy down” your interest rate by paying higher fees up front. To come out ahead, you’ll need to keep your mortgage for long enough to benefit from the lower interest rate. If you sell your home and pay off your mortgage early, you may end up having paid more for the lower interest rate than it saved you.  

In the world of student lending, you might want compare the cost of private student loans to federal direct PLUS loans. PLUS loans are currently offered to graduate students and parents of undergraduates at an interest rate of 6.31 percent.  But when you factor in the 4.27 percent upfront fee that’s taken out of PLUS loans before the loan is even disbursed, the APR on PLUS loans can be nearly 7.3 percent, if payments begin immediately.

Many private student lenders don’t charge upfront fees, particularly to borrowers (or borrowers with cosigners) with good credit. If you wanted to compare no-fee private loans to PLUS loans, you’d want to take into account the higher APR on PLUS loans. FinAid.org offers a calculator that helps you make such comparisons by taking the interest rate and fee of a loan you’re interested in, and generating the equivalent rate for a no-fee loan.  

Going beyond interest rates and APR

While it’s important to understand the difference between the interest rate and APR of a loan, neither give you a complete picture of your repayment costs.

Perhaps most crucial concepts to understand are your total repayment cost and finance charge. The finance charge is the amount that you’ll end up paying back on top of your loan principal. Your total repayment cost is principal plus the finance charge.

Because total repayment cost is affected by both the interest rate and the length of repayment, this is where focusing too much on APR can lead you astray. This is particularly the case with student loans, which typically offer many repayment options, ranging from deferring payments until after you’ve graduated, to making full, partial or interest-only payments while still in school.

Remember that a longer repayment term lowers the APR if the interest rate stays the same, but will increase the total amount repaid. Also keep in mind that private lenders usually charge higher interest rates for longer-term loans — the shorter the loan term, the lower the interest rate.

Ideally, you’d be able to compare loans using a chart like the one below, that shows not only interest rate and APR, but repayment term, origination fees, monthly payment and finance charge.

Cost to repay a $10,000 student loan at different rates, APRs and repayment plans

Interest rate Origination fee APR Repayment plan Repayment term Monthly payment Finance charge
6.0% 0% 6.0% Immediate 10 years (from loan disbursement) $111 $3,320
6.2% 3% 6.88% Immediate 10 years (from loan disbursement) $112 $3,740
6.2% 0% 6.2% Interest only during school 10 years (post graduation) $52/$112 $6,077
6.3% 3% 6.73% Interest only during school 10 years (post graduation) $53/$113 $6,481
6.4% 0% 6.11% Deferred 15 years $110 $9,812
7.2% 3% 7.12% Deferred 15 years $119 11,685

Source: iowastudentloan.org   

In the chart above, notice that a lower APR doesn’t always mean a lower finance charge. If you take out a 10-year loan with a 6.88 percent APR and start making 120 monthly payments of $112 as soon as you take the loan out, your finance charge will total $3,740.

If you chose another loan with an APR of 6.11 percent and defer payments until after graduation, then stretch out payments over 15 years to achieve roughly the same monthly payment, you’ll rack up finance charges equal to $9,812 above and beyond the amount you borrowed.

There’s something interesting about this loan — the APR is less than the interest rate. Remember the APR is not something you choose, or that the lender assigns to the loan — it’s a calculation.  

Sometimes the APR calculation assumes that unpaid interest is capitalized (added to the principle balance), while payments are deferred during in-school and grace periods. But if your lender instead waits to make that adjustment when repayment begins, the APR can be less than the interest rate when payments are deferred.

This is another reason not to rely on the APR alone when comparing loans and repayment plans. Lenders structure their fees and calculate APR in different ways, so the assumptions behind the APR can differ from loan to loan.

Another twist to keep in mind is that most private lenders offer a choice of a variable or fixed interest rate. You can lower your initial rate by choosing a variable-rate loan, but that rate can still go up or down in concert with indexes like the prime rate or LIBOR. And if your interest rate goes up or down, your APR will too.

If you’d like to learn more about fixed- and variable-rate loans, start with this post, “Fixed vs. variable rate loans: Know the difference.”

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