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The interest rate and the annual percentage rate (APR) on a personal loan are related, but they're not the same thing. An interest rate on a personal loan is different from an APR because an interest rate is simply a percentage of the loan you're charged for borrowing. An APR includes other fees charged as part of the lending process.
Here's the difference, and some guidance on how to understand both.
What Is an Interest Rate on a Personal Loan?
Interest rates determine the amount you pay for borrowing money. They are expressed as percentages and applied to the loan principal—the amount of money you borrow. It is very important to learn how personal loan interest rates work before getting one. Interest rates can be fixed (remaining the same for the life of the loan) or variable (subject to change over the life of the loan). Variable rates, more common with mortgages than with personal loans, typically are higher than the prime interest rate or another published market index, and are adjusted over the life of the loan, typically once a year.
For explanation purposes, we'll use an example of a typical five-year personal loan for $10,000 with a fixed interest rate of 9%.
Over the life of the loan, with monthly compounded interest, you'd expect to pay $2,455 in interest charges in addition to the principal $10,000, for a total of $12,455. Divided by five years of 12 payments each, your monthly loan charge would be $12,455/60, or $207.58 per month.
What Is the APR on a Personal Loan?
The annual percentage rate (APR) on a personal loan combines the interest rate with any fees associated with the loan. If there are no fees, the APR is the same as the interest rate, but lenders almost always add upfront charges known as origination fees to the cost of a personal loan.
Origination fees can range from 2% to 5%, and fees of 3% are typical. These fees do not affect the monthly payment or interest charges on the loan, but they are part of its total cost. APR changes to reflect them.
In our example of a $10,000 five-year loan at 9% interest, adding a 3% origination fee leaves the interest rate and monthly payment amount untouched, but increases the APR from 9% to 10.31%.
Differing interest rates, loan lifespans and fees make it tricky to do apples-to-apples comparisons between personal loans, so the APR is a helpful yardstick. A loan with a higher APR will cost more over the lifetime of the loan than one with a lower APR—even if monthly payments don't change.
APR vs. Interest Rate on Revolving Accounts
With revolving credit accounts such as credit cards, which let you borrow against a specific spending limit and make variable monthly payments, APR and interest rate are the same thing. The annual fees charged on some credit cards are not reflected in their APRs.
When comparing credit card APRs, keep in mind that many cards have several APRs, each of which apply to a different type of transaction. A low (or even 0%) promotional rate might apply to balance transfers added to the account when it was opened. The APR for purchases applies to ordinary charges made with the card. A higher rate typically applies for cash advances.
Having three interest rates apply to various portions of your monthly balance can be bewildering, and differing rules for applying payment to those partial balances can add to the confusion. Some cards apply payments to the highest-interest portion of your balance first, for instance, while others don't apply payments toward cash advances until all other partial balances are paid off.
You can use credit card APRs to compare the costs of using credit cards, just as you do with personal loans, but in practice, it can be a little more challenging.
How to Get a Great APR on a Personal Loan
The factors that determine the APR on a personal loan are similar to those used in all lending decisions. Lenders typically consider your credit report, credit score, employment history and income before extending a loan offer.
Often, lenders use credit scores to help decide which applications warrant full consideration—ruling out candidates whose scores don't meet a threshold for a particular loan. Applicants with lower credit scores may not even be considered for the loans with the best available APRs.
To get the best loan terms available to you, it can be worthwhile to take a few preliminary steps before you apply for a personal loan:
- Review your credit reports, including the one from Experian, for accuracy and submit any corrections to the national credit bureaus (Experian, TransUnion and Equifax).
- Check your credit score and take steps to improve it, including:
- Make sure to pay your bills on time. Every month, without fail. Missing just one payment hurts your credit score more than any other single credit decision you can make.
- Pay down your debts. High balances, especially those that exceed about 30% of your credit card borrowing limit, can have a negative effect on your credit score.
- Avoid applying for credit too often. Each time you apply for a loan or credit card, the lender checks your credit through a process known as a hard inquiry, which typically causes a temporary dip in your credit scores. Your scores usually rebound within the space of a few months as long as you keep up with your payments, but they don't have time to recover if you apply for multiple loans in short succession.An important exception to this is when you comparison-shop for loans. To encourage you to apply to multiple lenders when seeking a car loan or mortgage, credit scoring systems treat multiple applications for loans of the type and amount as a single event, which only lowers your score once.
- Apply to multiple lenders and shop carefully for the best deal.
The APR is a valuable tool when comparing personal loans. Understanding its relationship to interest rate can help you choose wisely when you shop for the loan that best meets your needs and budget.