If you’re thinking about getting a new credit card or want to refinance your home, chances are you’ve come across the term annual percentage rate or APR. But what is APR, and what does it mean in the context of borrowing money? And how does APR differ from the interest rate? Read on to learn more about the difference between interest rates and APR.
What is an Interest Rate?
According to the experts at SoFi Invest, the interest rate is a metric that calculates how much interest you will pay for borrowing money. You can express it as a percentage of your loan or investment amount, calculated over a specific period. If your annual percentage rate (APR) on a credit card, mortgage, or other loan is 16%, it means that if you borrow $100, you’ll need to pay back $116 in one year.
Before 1986, the interest payments on credit cards qualified as a tax deduction. However, that changed with the Tax Reform Act of 1986. Today, there are still some interest payments that qualify as tax deductible including:
- Interest from business expenses
- Interest on home equity loans, mortgages, and other home loans
- Interest on capital used to fund an investment property purchase
- Interest on unpaid student loans
Most reputable tax filing platforms offer an easy-to-use walkthrough approach which makes identifying any qualifying interest payment deductions easy. You can even file your tax refund forms for free. Of course, if you’re having trouble figuring this out, there are plenty of tax professionals available to help.
What Is an Annual Percentage Rate (APR)?
The annual percentage rate (APR) of a loan is a measure of how much interest you’ll pay to borrow money. Calculate APR by taking your yearly interest rate, multiplying it by the number of years you expect to take to repay, then adding one to get an effective annual interest rate.
The Differences between Interest Rate Versus Annual Percentage Rate (APR)
Calculating credit card interest varies from lender to lender. For example, some lenders will include fees in their interest rate, while others may not – so you might see slightly different numbers from different lenders.
All interest rates are annual rates, but not all APRs are annual. Some lenders use monthly or quarterly periods to determine their APRs. For example, a lender may add a $5 fee onto your balance every month as part of its interest rate calculation.
You don’t need to understand every little detail of calculating APRs to use them effectively. Just remember that they represent a full year’s worth of interest rates, while interest rates are annual rates that can change on a monthly or quarterly basis.
Types of APR Calculation
In order to understand the annual percentage rate, it’s important to understand that there are several ways in which a lender calculates an APR. Depending on how a lender calculates your loan’s APR, you may end up paying different interest rates for your loan. Let’s take a look at two of these methods: Regular or Simple APR.
Regular or Simple APR
This is calculated by adding together all finance charges for one year and dividing by that number plus one. This produces your regular or simple annual percentage rate. Some lenders might use an average daily balance instead of an average monthly balance to calculate your regular APR; it doesn’t matter either way because they produce comparable results.
Interest Rate Versus Annual Percentage Rate
There are two different ways to measure interest: The annual percentage rate (APR) measures how much interest you’ll pay on investment over one year. The simple annual rate of interest is what you earn for simply holding onto your money—it doesn’t take into account compounding or any other variables.
The annual percentage rate (APR) is a specific measure of annual interest charges for an adjustable-rate mortgage (ARM) based on monthly compounding. It is typically higher than simple interest rates calculated as a percentage of only principal repayments.