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?
APR (Annual Percentage Rate) represents the total yearly cost of borrowing, including the nominal interest rate and additional charges such as processing fees, service charges, or insurance costs. It provides a more accurate picture of what a loan or credit truly costs over a year. Unlike just the interest rate, which reflects only the cost of borrowing principal, APR captures the overall expense of financing. This makes it easier for borrowers to compare different loan offers and understand the actual financial impact of their borrowing decisions.
APR vs Interest Rate
Basis of Comparison |
APR (Annual Percentage Rate) |
Interest Rate |
Definition |
Represents the total yearly cost of borrowing, including fees and charges. |
Represents the cost of borrowing the principal amount only. |
Components |
Includes interest rate, processing fees, and other associated costs. |
Includes only the nominal interest charged on the loan. |
Purpose |
Provides a complete view of the actual loan cost to the borrower. |
Shows how much interest is charged on the borrowed amount. |
Transparency |
More transparent as it factors in hidden costs. |
Less transparent, may not include extra charges. |
Usefulness |
Helps compare different loan offers effectively. |
Useful for understanding the basic borrowing rate. |
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?
Interest rates or APR: which is better?
When comparing interest rates and APR (Annual Percentage Rate), understanding their difference is key to making informed borrowing decisions. The interest rate shows the cost of borrowing the principal amount, while the APR includes both the interest rate and any additional charges such as processing fees, insurance, or administrative costs.
For short-term loans or those with minimal fees, the interest rate may provide a good estimate of borrowing costs. However, for long-term loans like home or personal loans, APR gives a clearer and more accurate picture of the total cost over time.
Borrowers should prioritise comparing APR values when evaluating loan offers, as it reflects the true annual cost of credit. In contrast, interest rates alone may appear lower but could hide extra costs. Therefore, APR is generally the better metric for assessing affordability and transparency in lending.
Key takeaways
- The interest rate represents the cost of borrowing the principal amount and is usually disclosed at the time of loan approval or closing.
- The Annual Percentage Rate (APR) is generally higher than the interest rate since it includes additional borrowing costs such as fees and service charges.
- Under the Truth in Lending Act (TILA), lenders are required to clearly display both the APR and the nominal interest rate in all consumer loan agreements.
- Lenders must adhere to uniform regulations to maintain consistency and accuracy in the APR they disclose.
- Borrowers with excellent credit profiles and strong financial standing may qualify for promotional or 0% APR offers under specific lending conditions.
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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