If you have debt (or you’re thinking about taking on some debt), it pays to know the interest rate on the debt. Or should you know the APR? Wait, is there a difference between the two?
There is, and you should know both - the interest rate AND the APR (or annual percentage rate).
In this article, we’ll explain the differences between interest rate and APR and when you should consider one or the other.
What Is an Interest Rate?
An interest rate is the number (usually a percentage) that’s used to calculate the interest you have to pay on a loan.
To calculate the interest you’ll pay in a given month, you’ll multiply the amount you owe by the annual interest rate divided by 12.
For example, if you owe $30,000 in student loans at a 6% interest rate, you’ll pay $150 in interest charges. See the math: $30,000 x (6% / 12) = $30,000 x 0.5% = $150.
Of course, your payment will (usually) be higher than $150, so you’re paying off part of the principal balance of the loan each month.
That WTF Moment When You Start Understanding Interest
One of the worst parts about interest is how it affects your debt repayment. Let’s say you just made your first payment on that $30,000 of debt (at 6%) using the standard 10-year repayment plan.
That means you paid $333 towards your debt. You think your debt balance should be $29,667, right?
The first $150 of your $333 payment went to paying interest. The remaining $183 went towards your debt. The result? You still owe $29,817 in debt.
The bigger your loan balance, the more you’ll pay in interest expenses each month.
What About APR?
If interest helps you calculate the amount of interest you pay in a month, what is APR (annualized percentage rate)?
Many loans have costs associated with them aside from the interest rate. For example, a personal loan or private student loan comes with an origination fee. With mortgages, you’ll often pay closing costs, mortgage insurance, and even points (prepaid interest) right when you take out a loan.
Since these costs are one-time fees, they aren’t baked into the interest rate on a loan. But the costs are real, and it’s important to understand how they affect the cost of the loan. APR uses an interest rate to express how much the loan would cost on a yearly (annualized basis) assuming you pay off the loan as agreed.
For example, the interest rate on my mortgage is 3.75%. However, I paid one point (1% of the balance of the loan) and had closing costs of approximately 1%. The result? The APR on the loan is 3.95%.
The APR on a loan will almost always be higher than the interest rate on the loan. The only exception to this is if there are special incentives to close a loan, so the borrower gets money at closing.
When Should I Use APR?
The most important time to consider APR is when you’re comparing loans. The APR is the single number that tells you mathematically which loan is the best deal.
Unfortunately, comparing loans isn’t always as easy as looking at the APR and choosing the lowest number. If you plan to pay off a loan early (including moving or refinancing a mortgage after 5, 7 or 10 years), it’s important to consider that higher closing costs may make a loan less desirable even if it has a lower APR.
That caveat aside, choosing a loan with a lower APR usually is the best deal for a person.
When Should I Consider Interest Rate?
Once you already have a loan, the most important number to know is your interest rate. Your interest rate tells you how much the loan costs you each year. In general, if you’re trying to pay off debt, it makes sense to pay off the debt with the highest interest rate first.
The interest rate on your debt can also help you decide whether you should focus your money on paying off debt or investing (outside of retirement).
In the book, Broke Millennial Takes On Investing, author Erin Lowry interviewed dozens of investing experts. In general, these experts recommended paying off debts with interest rates above 5% before starting to invest. The exception to this rule is investing in a 401(k) or other retirement plan where you get an employer match.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.
Editor: Clint Proctor