Difference between interest rate and annual percentage rate (APR)

Definitions and meanings:

Interest rate:

Interest rate is a percentage rate that a lender charges from a borrower or a borrower pays to a lender on the principal amount of loan. This rate can also be called as nominal rate or note rate.

Annual percentage rate:

Annual percentage rate (APR) is the total cost a borrower bears for debt servicing. These costs include processing, documentation and origination fees, points, interest cost and mortgage insurance etc.

Borrower:

In a loan agreement, the person or institution who takes or borrows the loan payment is known as a borrower.

Lender:

In a loan agreement, the person or institution that provides the loan payment is known as a lender or issuer.

Principal Amount:

The amount of original loan is known as principal amount.

Difference between interest rate and annual percentage rate (APR):

The main difference between interest rate and annual percentage rate (APR) is explained below:

1. Nature:

Interest rate is basically the cost of the money to a borrower on a borrowed loan. This cost is calculated according to the percentage rate of interest and is payable according to the terms and conditions of loan agreement. APR or annual percentage rate is the effective cost that the borrower will have to bear if he or she takes a certain loan or enters a certain loan agreement. As in most of the cases, interest is a non-avoidable cost on a loan, APR includes other potential costs too that may be attached to a loan along with interest, which represents the effective percentage that the borrower will have to pay.

2. Example:

For example, Sheela Jenkins is an entrepreneur and wants to start a business of selling flowers. She needs a total cash of $8,000 to start her business but can only invest $5,300. Sheela goes to a bank to borrow a loan for the remaining amount. Bank offers her two rates:

Bank Lending Rate Bank Borrowing Rate
7% 5%

Now, if Sheela borrows the remaining amount for a period of one year and there are no other costs attached to the loan, the interest rate for Sheela would be the bank’s lending rate and effective cost:

Total cost of Loan/Interest payment = ($8,000 – $5,300) × 7%
= $2,700 × 0.07
= $189

The total repayment of Sheela would be $2,889 after the year or $240.75 per month. In this case, the Interest rate and annual percentage rate of the loan will be the same.

Now for example, Sheela’s bank charges a fixed fee based on size of the loan:

Loan Offered Fixed Bank Charges
Up to $5,000 $400
$5,000 – $10,000 $600
$10,000 – $20,000 $1,500
$20,000 or more Customized according to variables involved

The cost of loan to Sheela will be increased due to the bank’s fixed charges. To calculate the APR, the amount of additional cost will be added to the principal amount of loan. Nominal rate of loan (7% in this example) will be applied to this increased principal amount. The answer will be divided by the original loan amount to get the APR.

 

3. Decision making:

If more than one financing options exist, the borrower can differentiate based on the interest rate for each option if no other cost exists. However, if other costs including interest cost exist, annual percentage rate makes it possible for the potential borrower to compare two or more different financing options offering same interest rates but different APR’s that would normally vary based on differing loan terms and/or additional fees.

4. Practical application:

Interest rate is used to define the basic cost of a loan. This is the percentage which the borrower will be charged or the lender will receive. Banks and other financial institutions or intermediaries like insurance firms use this percentage to show their lending and/or borrowing rate. Usually, the borrowing rate of such institutes is lower than the lending rate. Large listed companies use interest rates to reveal the return to its bondholders. Annual percentage rate is applied for more complicated financial tools and instruments. Mortgage finance providers use APR to show the effective cost of the house. Financial institutes provide insurance facilities and/or credit facilities especially in terms of card cash, issue both interest and annual percentage rates for their clients.

Interest rate versus annual percentage rate (APR) – tabular comparison

A tabular comparison of interest rate and annual percentage rate (APR) is given below:

Interest rate vs Annual percentage rate
Nature
Is the percentage of cost the borrower will pay as interest. Is the effective percentage that the borrower will pay including interest and other costs.
Decision making
Can be used to compare different financing decisions if no cost other than interest is involved. Can be effectively used to compare different financing options if costs other than interest have to be paid.
Practical application
Is used by financial institutions to illustrate the cost to borrower for loans, bank leases, insurance plans etc. Is applied for more complex financing instruments like credit cards, mortgage finance etc.

Conclusion:

Both nominal interest rate and annual percentage rate depict the cost of debt financing for the borrower of loan. APR’s are different because they show the total cost and therefore are more reliable than the interest rates that can fluctuate according to the changing variables in a loan agreement. Annual percentage rates are normally equal or higher than the interest rates because they incorporate all the costs related to a loan including the interest payments. However, APR can be lower than the nominal interest rate in specific situations where a lender agrees to provide a subsidized loan on favorable terms.

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