The Difference Between Interest Rate and APR
By understanding APR and interest rates — and how they influence the total amount you’ll pay to borrow — you’ll be able to make choices that reduce the overall interest you pay.
July 26, 2021
If you’ve ever asked yourself what’s the difference between APR and interest rate, you’re not alone. Though the two terms are often used interchangeably — and in some cases, actually are equivalent — there are some situations where each rate is calculated differently.
Knowing what is the difference between interest rate and APR is an important part of making smart decisions as a financial consumer. By understanding APR and interest rates — as well as how they influence the total amount you’ll pay to borrow money — you’ll be able to make choices that save you money and reduce the overall interest you pay.
What Is an Interest Rate?
Put simply, the interest rate is the cost you pay to borrow the principal amount you’re financing. It’s typically expressed as a percentage and can be based on a number of different variables.
In the case of mortgage loans, for example, interest rates are generally influenced by the federal funds rate set by the Federal Reserve. It’s a common misconception that the Fed sets mortgage rates. Instead, changes it makes to the federal funds rate — as well as to other aspects of its monetary policy, such as buying or selling debt securities — may impact the 10-Year Treasury rate on which mortgage rates are more directly based.
When it comes to credit cards, interest rates are often expressed as a combination of index rates — such as the prime rate set by the Fed or the London Interbank Offered Rate (LIBOR) — and a margin rate that’s based on creditworthiness. When the index rate fluctuates, the amount of interest charged to the account may fluctuate as well.
What Is an APR?
The acronym APR stands for “annual percentage rate.” Unlike an interest rate, an APR is expected to take the full cost of lending into consideration. Again, this means different things for different debt vehicles.
When buying a home, your interest rate isn’t the only cost you’ll incur. That’s why your mortgage APR is typically higher than your interest rate — it’s accounting for additional expenses like closing costs, discount points, loan origination fees and even home insurance fees.
With credit cards, on the other hand, you don’t typically incur additional fees for borrowing (credit card APRs do not generally factor in expenses like annual fees). For that reason, credit card interest rates and APRs are typically considered to be one and the same. You’ll find important disclosures on credit card APRs in the ‘Schumer box’ on your statement (as required by the federal Truth in Lending Act) or in your account’s terms and conditions.
However, just because APRs and interest rates are considered equivalent for credit cards doesn’t mean you’ve only got one rate to worry about. Your account may have several different APRs associated with it, and how your interest is calculated will impact the total interest you can expect to pay.
Variable-rate versus fixed-rate APRs
Credit cards with variable-rate APRs fluctuate over time based on the movement of the index rate.
Fixed-rate APRs, on the other hand, do not change based on index rate fluctuations but can vary for other reasons, such as promotional rates expiring or a
being applied due to late payments.
Credit cards with a fixed-rate APR can also be converted to variable-rate APRs, provided the issuer offers cardholders appropriate notice of the change.
When you open a new credit card or transfer a balance, you may receive a promotional APR, deferred APR or balance transfer APR that will influence the amount of interest you pay for an introductory period or on the amount of the balance transferred.
The promotional APR on a balance transfer card doesn't typically apply to new purchases made with the card.
Cash advance APRs or penalty APRs
These may be triggered depending on your account’s activities.
A penalty APR may be triggered if you don't pay at least your minimum balance due on time. This higher APR is typically in place for at least six months until your credit card issuer reviews your account to determine whether it can be removed. A penalty APR will also void any promotional rate you may have had.
Daily APR versus monthly APR
: Whether your credit card uses a daily APR or monthly APR calculation may also impact the amount of interest you pay — especially if your balance fluctuates throughout the month.
All of these rates are set in advance and described in the card's terms and conditions.
The Difference Between Interest Rate and APR in Practice
To make the difference between annual percentage rate vs. interest rate clearer, let’s look at an example.
Imagine you’re taking out a $200,000 mortgage on a 30-year term and you’ve been given an interest rate of 4.5% by your lender. In this case, your interest rate is just that: 4.5%.
However, to take out the loan, imagine that you’ll also pay a 1% origination fee, pay for one discount point and be subject to $800 in additional fees. In this case, your APR is actually 4.703%. Your APR is higher than your interest rate because it fully accounts for the cost of borrowing money to buy your home.
Saving Money on Interest Rates and APRs
In the mortgage loan example given above, there are a few actions that you, as a buyer, can take to influence your interest rates and APRs. You may be able to negotiate elements like origination fees, closing costs and points paid (you may even ask that the seller cover some of these costs). If you don’t like the interest rate or other terms offered by one lender, you can seek out other lenders or improve your financial position to qualify for lower rates.
Similarly, you have options when it comes to the amount of interest you pay on your credit cards:
If your current interest rates are high, you can apply for accounts with other lenders that may offer more favorable terms. However, this is only likely to be effective if your financial position has improved since you last applied (don’t underestimate the impact of adding hard inquiries to your credit report).
You can also pay down debt, as a lower balance equals a lower total amount of interest — especially if your cards calculate APR on a daily basis. In that case, every day you carry a lower balance is a day you’ll be charged less interest.
Calling your credit card issuers and
may give you some relief. However, rate reductions can be difficult to come by, as issuers have little incentive to discount rates for anyone but their best customers.
Of course, the best way to save on interest charges is not carrying a balance on your accounts. But while you’re working on paying down debt, opportunities exist to accelerate your progress. Cutting your expenses to pay down debt can help, as can debt-management tools like Tally, which may be able to help you reduce credit card interest by consolidating high-interest cards into a lower-interest loan.
Give our Debt Payoff Calculator a try to see if Tally can help you reach your financial goals faster by reducing the interest rates you pay.