Understanding APR and interest rates isn't just smart—it's essential. When you borrow money, you should understand how much that debt is costing you, that’s why understanding APR and interest rates is so vital. Interest rates are the cornerstone of almost every financial decision, from choosing where to invest your money to where you take out a mortgage.
Below, we’ll go over how APR and interest rates affect your lending and finances and some tips for understanding what borrowing money is actually costing you.
An interest rate is a percentage amount of the total money borrowed that is charged for borrowing money. If you’re the one lending money, as when you invest money in stocks and bonds, then you’re the one getting paid the interest. If you’re the one borrowing, like when you get a loan, you’re the one paying the interest. An APR, or annual percentage rate, is the interest rate plus the fees associated with borrowing the money.
The Difference Between Interest Rates vs. APR
When you’re investing money, you want a high interest rate. For instance, a normal savings account has an interest rate that rarely keeps up with the inflation rate, stalling the growth of your extra money. A high-yield savings account, however, will have a higher interest rate, providing higher dividends to the account holder.
On the other hand, if you’re borrowing money, you’ll be looking for a lower interest rate. When borrowing money, it’s important to zoom out from looking at the interest rate and consider the APR when taking out a loan such as a mortgage or car loan. The APR for this type of borrowing will include the fees associated with borrowing that money. Those additional fees might include processing fees and closing costs. It may also include rebates. Unless rebates are in play, the APR will be the same as the interest rate or higher.
Mortgage APR or Interest Rate? Depends on the Situation.
Boiled down, the interest rate is what you pay for borrowing money and the APR is what you pay for borrowing money as well as the fees that the lender may charge to take out the loan. Here are two scenarios where a borrower might prefer to focus on either the interest rate or the APR.
- Arnie Anderson is taking out a mortgage. He is not planning on staying in the home long. Arnie may be wise to focus on a lower interest rate rather than a lower APR because his monthly payment will be lower and since they will be selling their house in five years, he won’t end up paying for all the fees that were tacked onto his mortgage in the beginning.
- Patsie Peppersmith is buying her forever home. She should look for a lower APR rather than a lower interest rate. That’s because she is planning on paying her mortgage through the fifteen or thirty-year mortgage period. She may be paying more per month but she’ll pay less for fees and her loan will cost less in the end.
How Interest Rates and APR affect your finances
It’s vital to know how much you’re paying to borrow money. Is the lender you’re borrowing from charging you plain old interest or are they going to charge you compound interest, which means they’re charging you interest on the interest you’ve already accumulated? This often happens with credit card debt, and debt can pile up faster than you might imagine.
Not all debt is bad. In fact, it’s often necessary. That’s why it helps to understand how APR and interest rates work differently with the three most common forms of borrowing.
- Mortgages: Look for low, fixed interest rates if possible. If you are concerned about paying a high interest over a thirty-year period you may want to consider a home loan with an adjustable interest rate. This is a favorable option if interest rates are expected to decrease in the future. Note that the APR is an important factor in determining the cost of your loan. Here is what is typically included in a mortgage APR:
- The Interest Rate
- Closing Costs
- Underwriting Fees
- Document Preparation Fees
- Origination Fees
- Car Loans: Car loans can vary greatly depending on where you’re shopping. At a dealership, the interest rate for a used car loan could range as high as 21%. With interest rates that high, you may end up owing more than the actual worth of your car. With all the predatory lending in the car loan space, it’s extra important to shop for a car loan before shopping for a car. If you want to be ready to buy a car once you find the right model, seeking pre-approval for a loan is a smart move. DCU has car loans at affordable interest rates with rate discounts for energy-efficient models. Don’t forget to consider the APR when taking out a car loan, much like a mortgage, financial institutions often charge fees for taking out the loan. These vary greatly depending on what lender you turn to, making the APR an important factor when shopping around for a car loan.
- Credit Cards: When you’re comparing credit cards the APR is less relevant than the interest rate. This is because many of the fees that are associated with the cards won’t be included in the APR as it’s impossible for credit cards to know how much credit their borrowers will incur and which fees they’ll be responsible for.
Another note about credit card interest rates: the credit rate is most relevant for those who may need to keep a balance on their card from month to month. To understand how much borrowing on a credit card will cost, it’s important to look at the interest rate as well as the fine print to understand the fees the lender may charge. DCU believes in being open and honest about credit card fees. Explore DCU credit card options.
APR and interest rates can have a long-term impact on your financial life. Committing to paying a loan with a low interest rate but a high APR can result in paying thousands more dollars than you thought you were agreeing to when you signed the loan agreement.
Are you finding that you’re already in over your head? Don’t be afraid to ask for help. Non-profit credit unions like DCU often offer one-on-one financial counseling and financial education to help members navigate themselves out of debt. If you’re interested in support, find out more about becoming a DCU member.
Tips for Navigating APR and Interest Rates
When you take out a loan of any kind, it’s vital to understand the fine print before committing to a loan agreement. There are certain details that are often buried that will make an impact on how much you’ll have to pay. Here are a few examples you might find in a loan:
- Is the interest rate fixed or variable? If it’s variable, when will it change?
- Are there late payment fees? What are they?
- Are there prepayment penalties for paying early?
As mentioned in a previous section, credit cards will not add many of their fees to the APR as their customer base is so varied. Be extra cautious when applying for credit cards as the fine print can hide many hidden fees. Here are a few fees to look out for:
- Penalty APR: This occurs after a period of nonpayment and triggers higher interest rates on your account. Generally, the penalty APR comes into play after 60 days but different lenders have different terms, so it’s important to know your lender’s policy.
- Balance Transfer APR: Many people save money when they transfer their credit card debt to cards with a 0% balance APR. This is typically a temporary APR giving you time to pay off your debt before the APR rises. As always, be cautious. Some credit cards with low balance transfer APR may have high interest rates when the introductory APR period is through. They may also come with annual fees or costly stipulations that could cost you if you try to close your account too early. Be sure and read the terms and conditions before applying.
- Foreign Transaction Fee: This common fee typically charges a percentage of the purchase you’re making at a foreign retailer. This may apply to online purchases as well as when you travel outside of the US. DCU and many other financial institutions offer cards with no foreign transaction fees, making leaving the country more affordable.
Your Financial Health
Now that we have APR and interest rates explained, we can dive into how carefully navigating the waters of loans and credit card usage can actually provide you with better interest rates.
A good credit score proves to lenders that you have had loans before and that you have a solid habit of paying on time. Are you interested in building a better credit score? Read our article on understanding and improving your credit score to get some information on how to begin.
Interested in tracking your credit score? DCU has a free credit score monitoring service for its members, allowing them to keep an eye on their credit scores without pulling their credit reports. As always, DCU is dedicated to providing financial education and services to those who need it. Knowledge is the key to a healthier financial future for all.
Please note, membership is required to open a DCU savings account. Visit our membership eligibility page for more information.
This article is for informational purposes only. It is not intended to serve as legal, financial, investment or tax advice or indicate that a specific DCU product or service is right for you. For specific advice about your unique circumstances, you may wish to consult a financial professional.
