It’s no secret that borrowing money costs money. But when it comes to telling you how much a loan will cost you, lenders may approach the matter from different perspectives: Some talk about their interest rate while others focus on their annual percentage rate (APR). Once you understand these terms and how they play into the total loan cost, you can make an informed decision before committing to a loan.
Interest Rate Is the Starting Point
A loan’s interest rate is the cost of borrowing the principal (the amount of the loan), expressed as a percentage of that principal. You can get an idea of the amount of interest you might pay on a loan by using the following simple interest formula for a fixed-interest loan: Principal x Interest Rate x Years. Let’s say you’re looking at a five-year, $10,000 loan with an annual fixed interest rate of 5%. You can calculate the simple interest this way:
$10,000 principal x .05 interest x 5 years = $2,500 in interest over the life of the loan
Annual Percentage Rate (APR) Adds Fees to the Mix
APR, which is also expressed as a percentage, more accurately reflects the true cost of borrowing, because it includes the interest rate plus any fees and other expenses associated with the loan. These costs may include application, processing, administrative and other fees, depending on the type of loan and the lender’s policies. If no additional fees are charged, the interest rate and APR will be the same; this is called a no-fee loan.
Compare Loans Using APR
When you’re shopping for the best deal on a loan, compare APRs rather than interest rates. Fees may vary widely from lender to lender, so using the all-inclusive APR should provide you with a more meaningful comparison. Borrowers sometimes believe that the loan with the lowest interest rate is their best choice, only to discover later that the fees charged on that loan outweigh any cost savings in interest.
- Will the lender be charging you simple interest (interest based on principal only) or compound interest (interest on not only the principal but also the interest)?
- Is the interest rate fixed (doesn’t change over the life of the loan) or variable (may fluctuate with market rate changes)?
- What fees and other costs will be included?
- What is the loan’s repayment term?