Whenever you apply for a mortgage, a credit card or a personal loan, you may see an interest rate plus a separate borrowing cost called the annual percentage rate, or APR.
So, why the two numbers?
Together, they give you a complete picture of the cost of borrowing, so you can get the most favorable deal when you're shopping around for credit. Read on to learn more about the difference between interest rates and APRs.
What is an interest rate?
When you use a credit card, take out a student loan or apply for a mortgage, the lender charges you interest, which is a percentage of your loan balance.
Simply put, interest is the basic cost of borrowing money.
Your interest rate can be variable or fixed, and is typically impacted by your credit score and how much money you're borrowing (your principal).
The majority of loans utilize simple interest, but credit cards complicate things with compound interest. That is, you pay interest on your interest.
What is APR?
With most types of loans, like personal loans, mortgages or auto financing, APR — not to be confused with the APY on deposits — refers to your yearly interest rate rolled up with some of the additional costs of taking out the loan.
Credit cards are the exception. With credit cards, your APR and the interest rate are the same thing. The annual rate is used to determine how much extra you'll owe when you carry a balance on your credit card from month to month.
But with the other kinds of loans, think of your interest rate as the base cost of borrowing money month to month, while APR refers to an overall cost of borrowing once fees and expenses are included.
It's important to note that lenders don't have to include all costs in the APR, so — when you're comparing loan terms — be sure to find out what is and is not included in the APR.
Comparing interest and APR
Here's how APR and interest rates compare on mortgages:
Let's say you want to buy a $200,000 home.
Option 1: You're offered a 30-year fixed-rate mortgage with an interest rate of 3.875% and an APR of 4.274%.
Note that the 4.274% APR might include discount points, mortgage broker fees and other charges that you pay to get your mortgage.
Option 2: You're offered a 15-year fixed-rate mortage with an interest rate of 2.75% and an APR of 3.00%.
On any mortgage, the APR will usually be higher than the interest rate, because the APR is your interest and more.
Whether you choose a 30-year or 15-year mortgage depends on whether you want to save money now or over the long haul.
Longer-term mortgages have higher interest rates and cost more over the lifetime of the loan, but your monthly payments will be more reasonable than the payments on a shorter-term loan.
Option 1 could be a smart move if you're a first-time homebuyer, you're looking for a lower payment, and you think you'll be moving within five years. If you're likely to stay put and can afford to pay more each month, Option 2 will cost you less in the long term.
Either way, you'll have an interest rate — and an APR.
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