What is APR? How does APR differ from standard interest rates?

Article Category: Finance  |   

APR featured on loan statement - photo

In an ideal world, taking a loan would be simple. Apart from filling out the paperwork and receiving approval all you'd need to know is the amount of interest you have to pay. Take out $1,000 at 5% and your total repayment sum comes to $1,050. But, depending on the terms of your finance, on top of this you'll need to consider any additional costs such as processing fees, etc.

Simple, right? In theory, yes. The confusion starts to set in once you factor in APR (Annual Percentage Rate).

Before we move on to look at the specifics of APR, let's start with some very basic explanations.

What exactly is an interest rate?

An interest rate is a fee, calculated as a percentage of the total loan amount, that you are charged for borrowing money. Most lenders refer to this as a base rate.

What is APR?

We've already delved into the question, what is compound interest and how can it help you?. But to save you having to jump back and forth between pages, here's a quick explanation:

When you take out a loan the lender calculates interest on a sliding scale. This figure is then used to work out what your monthly repayments will be.

Here's a quick example:

You borrow $1,000 with an APR of 3% over 3 years (assuming an annual APR calculation).

Year 1 interest: 1,000 x 0.03 = 30 and 30 + 1,000 = 1,030
Year 2 interest: 1,030 x 0.03 = 30.9 and 30.9 + 1,030 = 1061
Year 3 interest: 1,061 x 0.03 = 31.83 and 31.83 + 1,061 = 1,092.83

In total, you'll pay back $1,092.83 at the end of the finance period.

Note: advertised APR figures are normally higher than the advertised interest rate because lenders bundle additional costs and fees into the rate shown. For peace of mind, and to ensure you know what you're going to pay, ask your lender exactly what fees are included in the APR figure they offer you.

So, what is the difference between interest rate and APR?

We've touched on it very briefly already, but let's go a little deeper. When you accept any kind of loan offer you should be shown two interest rates: the APR and the flat rate of interest.

The yearly interest rate you see is exactly what it says: it's only the charge (in the form on interest) that you pay for borrowing money. There are no grey areas here - if the figure is 10% then that's the base rate you'll be charged. So, if you're lucky enough to find a lender who charges you only $45 for borrowing $1,000 then the rate you pay is 4.5% (45/1000).

Annual Percentage Rate (APR)

As we noted earlier, the way APR is calculated is a little more complex as it combines a number of additional fees charged by your lender. Included in the cost are prepaid interest, insurance, closing fees and any other costs that may be associated with the transaction. Combined, these factors mean the APR you're shown is higher than the base rate that lenders use to advertise their loan plans.

Another factor to consider is the cost of moving loans from one supplier to another. APR is worked out on a sliding scale and your lender shows you figures based on the assumption that your debt will be held by them until it's finally paid off. If at some point you decide to shift your debt to another company then we strongly advise you check the sums. Although those lower interest rates look very appealing, if you keep jumping from one supplier to another, you might end up paying far more over the term.

As with any form of lending, it's important to understand the terminology that money lenders wrap around their offers. But, even more important, having a reliable tool you can use to work out the financial impact of borrowing money will stand you in excellent stead before you even start the application process that's why we've created an interest rate calculator to give you an accurate view of both the interest and APR payments you'll be required to meet. If you would like to learn more about the different types of interest rate, read our article, what is the difference between nominal, effective and APR interest rates?

Written by James Redden

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Last update: 31 May 2013

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