Interest Rate vs APR

While the interest rate specifies the cost of borrowing money, the annual percentage rate (APR) provides a more comprehensive view of the total borrowing cost.
EXPLORE FUNDS
Interest Rate vs APR
EXPLORE FUNDS
3 min
22-June-2024

The interest rate on a loan represents the expense incurred for borrowing funds from a lender. The Annual Percentage Rate (APR) measures the interest rate along with any supplementary fees associated with the loan. Both interest rates and APR are expressed as a percentage.

If you are applying for a home loan or any kind of loan? While choosing a loan, you may come across certain terminologies such as interest rate, APR, and many others. But what are they? What are the differences between interest rate and APR? Let us explore the comparison of interest rate vs APR in more detail.

In this article, we will explore the meaning and concepts of interest rate and APR, how they are calculated, how they differ from one another, and which one is more important while taking a home loan.

What is an interest rate?

Interest rate is the percentage rate that a consumer pays a lender for a certain period of time, say, 3 years, 5 years, 10 years, 15 years, or so on. Essentially, the interest rate is the cost a borrower has to pay the lender for borrowing money from the lender for a certain time span.

The interest rate at which you are paying a lender can either be fixed or variable.

  • In the case of fixed-interest-rate loans, you will have to pay a fixed amount throughout the entire span or term of the loan.
  • In the case of variable interest rate loans, the interest rate is dependent on the market rates. Therefore, variable rates may fluctuate as per the market conditions.

A loan borrower has to repay the lender money on the basis of two components:

  • The principal amount of the loan you borrowed
  • Interest on the borrowed money

It is important to note that no fees or charges are associated with the loan payment.

What is an APR?

The full form of APR is the Annual Percentage Rate. APR is the yearly cost of a loan. It includes the interest rate and other fees that a borrower has to pay the lender for borrowing a loan or mortgage.

Difference between interest rate and APR

Both interest rate and APR are expressed in percentage form. The main difference is that APR will always be higher than the interest rate. This is mainly because APR includes all kinds of fees you have to pay a lender in addition to the interest rate.

  • Interest rate, essentially, gives you a benchmark that helps you compare various loans. This helps you know the associated costs of loans from different lenders.
  • When you are shopping for a mortgage or any other loan, this will be helpful. Interest rates will give you a quick comparison of the costs you have to bear when you take a loan from different lenders.
  • APR or Annual Percentage Rate also provides you with a benchmark that helps you compare loans from various lenders. In comparison to interest rates, APR provides you with a more vivid picture of the associated cost of borrowing.

APR includes:

  • Cost of borrowing (which is essentially the interest rate)
  • Costs associated with borrowing the money from the lender (which may include monthly fees, processing fees, upfront fees, applicable charges, or any other cost)

In comparison to interest rates, APR provides you with a more vivid idea about the true cost of a mortgage or other loan. Whether you are applying for a secured loan or an unsecured one, APR is applicable for both. You can compare interest rates and APR for all kinds of loans including credit cards, student loans, personal loans, car loans, home loans, and others.

Also read about - What is Treynor ratio?

How are interest rates calculated?

Interest rates are calculated as a percentage of the principal amount borrowed, expressed annually. The formula for simple interest is:

Interest = Principal × Rate × Time

Where:

  • P is the principal amount (the beginning balance).
  • R is the interest rate (usually per year, expressed as a decimal).
  • T is the number of time periods (generally one-year time periods).

How is APR calculated?

The Annual Percentage Rate (APR) is calculated by combining the interest rate and other fees associated with a loan. The formula for calculating APR includes the principal amount, interest rate, and loan term. Here is the step-by-step process:

  • Interest rate: Determine the interest rate on the loan.
  • Finance charges: Add any fees associated with the loan, such as origination fees.
  • Total interest: Calculate the total interest paid over the loan term using the interest rate and principal amount.
  • Total payments: Add the total interest to the total finance charges.
  • APR calculation: Divide the total payments by the principal amount and multiply by 100 to convert to a percentage.

Also read about - What is a Sharpe Ratio?

APR vs Interest rate with Example

Let us assume that you have borrowed a home loan of Rs. 80 lakhs from a lender at an interest rate of 7.2%.

Here are some of the essential details of your mortgage:

  • Total mortgage amount = Rs. 80,00,000
  • Interest rate = 7.2%
  • Loan processing fee = 0.5% of total loan amount = Rs. 40,000
  • Loan term = 30 years

For simplicity, we are considering a simple mortgage calculation.

In 30 years, you will have to pay Rs. 1,95,49,100.43 (Principal amount + interest amount). Besides the principal loan amount, you have to pay an extra of Rs. 1,15,49,100.43 over 30 years.

This means you have to pay:

  • APR = Rs. 6,51,637 approximately
  • Annual interest payment = Rs. 3,84,970 approximately

Please note that the interest payment and processing fee are your cost of borrowing the mortgage. In the 30 years of loan tenure, you will be required to pay the lender the principal amount of Rs. 80 lakh, the interest amount, and the other costs.

While interest payment only includes the interest you have to pay the lender for borrowing, the APR calculation includes interest payment plus an additional fee (such as a processing fee).

As per this simplistic mortgage calculation, you will have to pay your lender 6,51,636.72 per year or Rs. 54,303.06 per month as EMI.

Tips for Comparing Interest Rates and APRs

  • Understand the interest rate: The interest rate is the percentage of the loan amount that you pay in interest charges to the lender. It directly impacts your monthly loan payments.
  • Consider the APR: The APR includes the interest rate and any additional fees or charges associated with the loan. It provides a more comprehensive picture of the total cost of borrowing.
  • Check for fees: Additional fees can significantly impact the overall cost of borrowing. Ensure you understand all fees associated with the loan.
  • Compare offers: When comparing loan offers, consider both the interest rate and the APR to make an informed decision.
  • Check for compounding: If you are comparing credit cards or other revolving credit, ensure you understand how compounding affects the interest rate and APR.

Also read about - What is the interest coverage ratio?

Conclusion

Learning about the difference between interest rate and APR is very important as both have their own advantages. While interest rate gives you an idea about your cost of borrowing, APR gives you an idea about the total cost. Interest rate gives you a benchmark to compare various loans, especially at the time of loan shopping. However, when it comes to understanding your loan’s true cost, APR is more helpful. By learning about the annual percentage rate, you can budget accordingly and also plan how to pay off your loan comfortably.

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Frequently asked questions

Which is better APR or interest rate?
APR is better for understanding your total cost of your loan. It helps you budget accordingly and create a preferred schedule to repay your loan. Interest rate, on the other hand, acts as a benchmark to compare loans among various lenders. It helps you choose a loan at the time of loan shopping.
What is the difference between APR and fixed interest rate?
In the case of fixed interest rate, you have to pay the interest amount at a fixed rate, say, 8 per cent. In the case of APR, you will have to pay both interest amount and other associated charges such as processing fee.
How is APR calculated?
To calculate APR, you have to multiply the total periods in a year applied for and the periodic interest rate.
What is a good APR rate for a loan?
10.45 to 12% can be considered a good APR for a personal loan in India.
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