APR vs. Interest Rate
Understanding APR and interest rate can be daunting. But it's essential to know the difference in order to save money and get the right product for you.
When looking to access a line of credit such as a student loan or credit card, you will undoubtedly come across the terms APR and interest rate. And while these terms are regularly used in the world of lending, they can often be confusing or difficult to understand. Is APR the same as interest rate? Is it something that involves complicated calculations? Will I incur hidden fees on top of this? These are all valid questions that come up, particularly for students who have never taken a loan before. So, let’s take a closer look.
Understanding Interest Rate
When accessing a loan from a financial institution, you typically borrow a set amount which is known as the principal. This amount will always need to be paid back, however because the lender takes a risk in providing these funds, they will charge a percentage above the principal in the form of an interest rate. You should think of this rate as the cost of borrowing money, sort of like hiring a car. You’re paying for the benefit to have funds now and return it at a later date.
So, with the principal and the interest rate combined, that’s all that you have to pay back, right? Well, not necessarily. Often lenders will add other fees and charges to the total amount in order to cover the costs of lending the money. These fees will vary widely by company, so it can quickly become a complex game in understanding which lender offers the overall best cost to you. To combat this, the EU has created comprehensive consumer protection rights that require financial institutions to provide a more comparable number in the form of an APR.
What is APR
Annual Percentage Rate, or APR, is the annual rate charged by a financial institution to loan its funds to borrowers. And while it does include the interest incurred on the credit, it also takes into account all of the other fees that may fall outside of this one variable. This could include fees to originate the credit, fees to service the loan, or even a fee to repay early. Once all of these costs have been combined with the interest rate, a total yearly rate is established to form the APR which can then be divided by twelve to understand the true monthly rate.
It’s important to note that there are different types of APR, so you should always check before signing on the dotted line. Loans are typically offered with either a fixed rate or variable rate. A fixed APR means that the interest rate will not change during the life of the loan. A variable APR, on the other hand, indicates that the interest rate may fluctuate during the course of the loan duration. Both of these loan types will have their pros and cons but it’s important to understand that a variable APR will typically follow the market interest rate, whether that rate goes up or down over a period of time. This could either save you money or cost you money in the long term.
Transparency and standardisation in APR
The goal of APR being used in financial lending is twofold. First, it provides consumers with transparency, and second, it provides them with standardisation. This means that it will be easier for you to understand the exact makeup of your monthly payments by distinguishing the interest rate from any additional fees. Because of this clarity, you can then compare loan products at various companies in order to get the best overall rate and save money.
So, at the end of the day it’s important to distinguish between APR and interest rate. The former will be more likely to tell you the true cost of your loan and provide you with a secure frame of mind when signing a loan agreement. The latter will disregard additional fees that cause an increase to your monthly payments. Transparency and comparability are key when researching financial products, so be sure to do your homework when shopping around and make sure you get the APR that is best for you.