APR vs interest rate: which figure shows the real cost of a loan

The interest rate is the price of borrowing the money, charged on the balance you still owe. The annual percentage rate, APR, is a wider figure. It also takes in certain fees the lender requires, and spreads them over the loan, so it shows more of the yearly cost. When two lenders quote you for the same amount and term, compare APRs, not interest rates. In many countries lenders must show an APR, although the rules on which fees count differ.

Why the two figures differ

Take a loan of $10,000 at 6% a year, repaid over five years, with a $300 arrangement fee taken from the amount at the start. You receive $9,700, but the repayments are worked out on the full $10,000 at 6%. The interest rate is still 6%, because that is what the repayments are based on. The APR asks a different question: what single yearly rate makes the repayments worth the $9,700 you actually received?

Worked out that way, the repayments are $193.33 a month for 60 months, and the APR comes out at about 7.3%. That figure is the monthly rate multiplied by 12. Some countries annualise the effective monthly rate instead, which for the same loan gives about 7.5%. Both methods are used, so the figures are only comparable when both quotes use the same one. Ask which method a quote uses before you compare.

The fee does not change the monthly payment in this example, but it changes what the loan really costs. That gap is what the APR is meant to show. The exact fees that count, and how they are spread, are set by each country's rules, so use the APR printed on the offer rather than one you work out yourself.

What the monthly payment depends on

The monthly payment depends on three things: how much you borrow, the interest rate and the term. It comes from this formula:

payment = P × r ÷ (1 − (1 + r)^−n)

Here P is the amount borrowed, r is the monthly rate (the annual rate divided by 12 and by 100), and n is the number of monthly payments. The formula uses the interest rate, not the APR, because fees paid separately are not part of the repayment schedule. A fee added to the loan balance does raise the payment, so check how each fee is handled.

For $200,000 at 6% over 30 years, the payment is $1,199.10 a month. The first payment is mostly interest. At 6% a year, one month's interest on $200,000 is $1,000.00, so only $199.10 of the $1,199.10 payment reduces the debt. The share that goes to the balance grows each month as the balance falls, which is why early repayments feel slow.

Shorter terms cost more a month, less in total

The same $200,000 at 6% gives these results for two terms:

The 15-year payment is about 41% higher each month. The total interest is less than half of the 30-year figure. Interest is charged on the balance, and a 15-year loan clears that balance in half the time, so there are far fewer months in which interest can build up.

This is a choice about cash flow. A shorter term needs more room in the monthly budget. A longer term lowers the payment but adds interest for every extra year. The loan calculator shows both the monthly payment and the total interest, with a year-by-year balance, so you can compare terms with your own figures. It leaves out lender fees and insurance, so its totals are the interest and repayments only.

Comparing two offers

1. Make sure the amount and the term are the same. An APR only compares like with like.
2. Compare the APRs, then ask what fees are in the total each lender quotes, and what is left out.
3. Enter the rate into the loan calculator to see the monthly payment and total interest. Those totals do not include fees, so add the fees separately when you judge the offer.
4. If you plan to pay extra each month, the guide to extra payments shows how that changes the total.
5. If you plan to repay early, look up any charge for doing so. It is not always part of the headline figures.

Edge cases

• Variable rates. An APR quoted for a variable-rate loan assumes the rate stays where it is. If the rate changes, the true cost changes with it.
• Introductory rates. A low starting rate may be followed by a higher one. Ask what rate applies after the introductory period, and work out the payment at that rate.
• Zero-interest deals. A deal with no interest can still carry fees. The APR shows those fees, and the interest rate does not.
• Monthly and yearly rates. A monthly rate of 0.5% is not the same as a yearly rate of 0.5%. Multiply a monthly rate by 12 to get the yearly figure, the way the APR in this example is worked out.
• Rounding. Lenders round each payment to the cent, so an exact calculation can differ from the bank's schedule by a few cents.