The Annual Percentage Rate (APR) of a loan is the total cost of that loan, including interest and fees, combined and expressed as an annual percentage of the amount you borrow. The interest rate, on the other hand, is a simple percentage of the total amount you are borrowing.
APR is a more comprehensive rate covering the total cost of a loan. If there are no fees or other costs, the APR and the interest rate will be the same. Most personal loans come with an origination fee, however, so the APR will usually be higher than the interest rate because it includes both the interest rate and the fees.
Understanding the difference between an interest rate and an APR can help you compare the costs of different loans more accurately.
What Is the Interest Rate on a Personal Loan?
The interest rate is a percentage of the loan principal that is paid by the borrower. Essentially, it is the amount that you pay for the use of someone else’s money. For example, if you borrowed $1000 for one year at a simple annual interest rate of 10%, you would pay $100 in interest. If the interest rate was 12%, you would pay $120 in interest, and so on.
Interest calculations for actual loans are not usually that simple, however. Lenders may use different systems for computing interest and distributing interest payments over the lifetime of a loan. Your lender may be able to provide an amortization schedule that shows you how much of each monthly payment will go toward interest and how much will go toward paying off the principal at each stage of the loan’s term.
Interest rates may be fixed or variable. A fixed interest rate is set for the life of the loan, a variable interest rate can change according to prevailing market interest rates. Most personal loans have fixed rates.
What is the APR on a Personal Loan?
The Annual Percentage Rate or APR is the total cost of a loan, including interest and any fees or other expenses. These costs are added together and stated as an annual percentage of the loan’s principal. Because the APR includes all of the costs of a loan, comparing APRs gives a more accurate basis for a head-to-head comparison of different loans with different terms, fees, and interest rates.
Most personal loans have an origination fee, which often ranges from 1% to 8% of the loan’s total. The origination fee is usually deducted from the amount you get when you receive the loan. Loans with higher origination fees may have lower interest rates.
It may be difficult to compare the cost of different loans that have different terms, interest rates, and fees. The APR includes all costs and is the most equal basis for comparing different loans. The loan with the lowest APR will have the lowest total cost to the borrower.
How to Get the Lowest Possible APR on a Personal Loan
Lenders usually base your interest rate and the fees they charge on the level of risk they think you pose. They will assess your credit score, credit report, income, employment history, and other factors. A borrower who is perceived as a low credit risk will usually be offered a better interest rate and lower fees than a more risky borrower. A lower rate and lower fees add up to a lower APR.
There are steps you can take to get the best possible APR on your personal loan:
- Start by getting your credit score and credit report.
- Look for errors on your credit report that could be hurting your credit. Up to 20% of credit records contain inaccurate information, and errors can damage your credit.
- If you find errors, initiate a dispute resolution process with the credit reporting company.
- Look for items on your credit report that could harm your credit. You may wish to pay off some debts or high balances on accounts. This may improve your credit utilization, which can affect your credit and can improve your debt-to-income ratio, which many lenders consider when calculating your interest rate and fees.
- Minimize your credit applications or other actions that could generate inquiries on your credit report, especially if you know you’ll be applying for a loan soon. Inquiries can harm your credit.
- Always apply to several lenders and compare the terms they offer. Even with the same credit information, different lenders may offer very different terms. Compare the APRs on your offers to see which has the best terms.
Finding the loan with the lowest APR may help you to get the loan you need at a better price.
Is the Cheapest Loan the Best Loan?
The APR will tell you which offer has the lowest cost over the entire term of the loan. That’s an important factor, but it’s not the only thing you’ll want to consider. In some cases, you may not want to choose the cheapest loan.
- For some borrowers, keeping the monthly payment affordable is more important than getting the cheapest loan. A loan with a longer term could have a lower monthly payment, even if it has a higher APR. The total cost of the loan will be higher, but if that smaller monthly bill prevents a missed payment, it could be worth it. Missing payments can harm credit, and that can be expensive.
- Some borrowers also prefer to receive as much of the borrowed money as possible upfront. Origination fees are deducted from the money that is paid out at the start of a loan, so a high origination fee will reduce the initial payout. These borrowers may prefer a loan with a low origination fee even if it has a higher APR.
If you are in one of these situations, you may be willing to accept a higher APR in order to get a loan with features that you want, like a low monthly payment or a low origination fee. Comparing the APRs on the loans will tell you what you are giving up to get those features, and that’s an important factor in deciding whether the tradeoff is worth it.
Choose the Right Loan For You
The APR is a useful tool that gives you a head to head comparison of the total cost of each loan proposal. You can select the least expensive personal loan by comparing the APRs of the loans you’re offered. In some cases, the cheapest loan may not meet your financial objectives. The APR still provides a great basis for weighing the advantages and disadvantages of each loan proposal. Even if you don’t choose the loan with the lowest APR, you’ll know exactly what you’re giving up, and what you’ll gain.
Whatever your priorities, it’s important to have head-to-head comparisons that allow you to evaluate loans on equal terms. The APR provides that, making it one of the most important factors in evaluating personal loans.