I consider myself someone who currently is pretty financially literate. Not perfect. But in a way better place than I was when I started out clueless with a net worth of -$500k. Despite this, until just a couple days ago, I had no idea what the difference was between interest rate and APR.
In fact, I never even really thought to look into the difference before.
Despite seeing both terms thrown around all over the place – in car commercials, mortgage documents, and even investment prospectuses – I never got curious. Until I recognized a small pattern. That the APR was always higher than the interest rate when taking on debt. And down the rabbit hole I went.
The difference between interest rate and APR
And now I’m here to share my rabbit hole findings.
What is interest rate?
Most of us have a decent general understanding of was an interest rate is. It’s essentially the cost of borrowing money if you are taking on debt. And if you are investing, it is the expected return on your investment – the profit you make for risking your money on that particular investment.
So, for example, let’s say you take a mortgage out to buy a $200,000 house and the interest rate is 5%. That means that annually you will pay $10,000 in interest ($200,000 * 0.05%) or $833.33 monthly. Keep in mind that this example uses nominal interest and not the amortized interest schedule that mortgages use in the real world. But it does the job of illustrating the point.
On the converse, let’s say that you invest $100,000 in the overall stock market via low cost, broadly diversified index funds for the long-term average of 7% return (interest rate). This means you would expect an annual return of $7,000 (at least the first year before compounding increases your returns).
Simple enough. That’s interest rates.
What is APR?
APR stands for Annual Percentage Rate.
And this number includes not just the interest rate on whatever debt purchase you are making. It also includes all other fees and expenses. Things like loan origination costs, points paid on the interest rate, closing costs, etc.
Let’s jump straight to an example. Take the mortgage that we used above. It’s a $200,000 mortgage with a 5% interest rate which totaled $10,000 in annual interest costs. But, there were also $12,000 of other fees and such attached to this loan. Now, your total cost is $212,000 at 5% interest for a new annual payment of $10,600. If we divide this amount by the original loan amount of $200,000 we get an APR of 5.3%.
Why does this difference between interest rate and APR matter?
You may be asking yourself this question now. And I get it. Because the difference between an interest rate of 5% and an APR of 5.3% in the above example seems pretty negligible.
But this stuff can really matter. Or else no one would have made up these two numbers. Right? Sellers (of loans) come up with different ways to represent numbers that are often distracting at best or misleading at worst. To their benefit.
So let’s take a closer look
Again, numerically, this is a small difference. But it is an important one. Because the APR is a more accurate representation of total loan cost than interest rate.
Basically, interest rate takes the short view and APR takes the long view. And what is best for you – the person taking on debt – in the long term is best. But what is best for the person giving the debt is for you to focus on the short view. And that is why interest rate (by definition the less accurate and also lower of these two representations of true loan costs) is bandied about more frequently.
For example, let’s say that you plan to take on a car loan for $50,000. And the dealer gives you a choice between a 5% interest rate and a 4% interest rate where you have to pay 2 points (~2%). In this case, you will have a lower monthly payment with the 4% loan but will actually be paying much more in the long term. Thus, the higher interest rate may actually make sense!
Which begs the questions…
When is focusing on interest rate better?
Generally, focusing on the interest rate is better if you plan to keep the loan for a short period of time. This is because it’s lower monthly payments despite a higher overall cost to the loan.
Examples would be a house you are buying but plan to stay only a few years (not a good idea!) or something like that.
When is focusing on APR rate better?
Pretty much anytime that you are planning on keeping the loan for a longer time. Monthly payments may be higher but overall cost will be lower.
But really you should be making both of these numbers irrelevant!
Because you should be paying off old debts aggressively. Not letting them sit around. And you should be making new large purchases – like a car – in cash, not with loans.
In fact, the only time I care about this
…is when I am considering terms on any instances of good debt that I am accruing. And remember, good debt is debt that pays me to hold it.
In my case, that is through active real estate investing where Selenid and I buy house with mortgages that are paid off by tenants’ rent with cash flow going into our pockets. In these instances, we are using 30 year mortgages that we plan to hold long term. Thus, focusing on APR makes more sense to us.
And that is the bottom of my rabbit hole on the difference between interest rate and APR
Is this difference going to make or break your path to financial freedom? No way.
But they can make a real difference. So it’s something worth paying a little attention to. It’s also always interesting and fun for me to see how these numbers are contrived to throw us off and how we can avoid their intended pitfalls.
Lastly, and most impactfully, thinking about interest rate and APR calls back to some foundational wealth building habits and strategies like:
- Balancing paying off debt with investing
- Considering the impact of debt on your net worth scorecard
- Taking the long term view with your financial plan
What do you think? Did you know what interest rate and APR really represent? Do you think it matters or are we splitting hairs? Let me know in the comments below!