APR vs. interest rate: when the lower number is not the cheaper loan

For comparing installment loans, the APR is the better number. The interest rate only tells you what the lender charges on the balance; the annual percentage rate folds in required finance charges such as origination fees and discount points and expresses the total as one yearly rate. There is one big exception: the APR assumes you keep the loan for its full term, so if you plan to pay it off early, a no-fee loan can win even when its APR is higher.

What each number includes

The interest rate is the price of the money itself. It is applied to whatever you still owe, and it alone sets how much of each payment goes to interest.

The APR is built from that rate plus the finance charges the lender requires you to pay to get the loan. Under Regulation Z, the rule that carries out the Truth in Lending Act of 1968, finance charges include “points, loan fees, assumption fees, finder’s fees, and similar charges.” Lenders have to disclose the APR before you sign, which is why it appears in the same place on every personal loan agreement and every mortgage Loan Estimate.

The two federal rate series this site tracks show the difference. The Federal Reserve’s average for a 24-month personal loan at commercial banks is reported as an APR:

Freddie Mac’s weekly average for a 30-year fixed mortgage is a contract interest rate, before points and fees, so the APR on a real mortgage offer will usually be higher than this figure:

How an origination fee changes the math

An origination fee is a one-time charge for processing the loan. Many personal loan lenders take it out of the proceeds, so on a $10,000 loan with a 5% fee, $9,500 reaches your account while you repay $10,000 plus interest. You pay interest on $500 you never received.

That also means you have to borrow more than you need. To end up with $15,000 in hand after a 5% fee, you would have to borrow about $15,790, because $15,000 divided by 0.95 is $15,789.47. Ask the lender whether the fee is deducted from the proceeds or added to the balance, and size the request accordingly.

A worked comparison: which loan wins, and when it flips

Say you need $10,000 in hand and get two offers. Lender A charges a rate of 10% plus a 5% origination fee, so you would borrow $10,526 to net $10,000. Lender B charges a rate of 12% and no fee. Here is what each costs at different terms, computed with standard amortization:

The answer flips between 68 and 69 months. At 68 months Lender A’s APR is 12.003%, a tie for practical purposes, and from 69 months on it drops below 12%. The pattern holds for any fee loan: the fee is paid once, so the longer it is spread out, the less it adds to the yearly cost. On short loans an upfront fee is expensive; on long ones the lower rate eventually makes up for it.

Notice that the APR ranking and the dollar ranking agree once both offers put the same $10,000 in your pocket. Comparing total payments on loans that deliver different amounts of cash is the most common way to get this wrong.

Paying off early can reverse the result

The table assumes every payment is made on schedule. Suppose you take Lender A’s 84-month loan, the one that wins on paper, and pay it off after 24 months. You paid the whole fee for two years of borrowing, and your effective cost rises to an annual rate of 13.16%, while Lender B’s stays at 12% because it had no fee to spread out. In dollars, Lender A costs $12,419 in total against $12,172 for Lender B. In this example, if you pay the 84-month loan off before roughly 48 months, Lender B would have been cheaper.

So the rule is to compare APRs for the term you expect to keep the loan, not the term on the contract. If there is any real chance you will refinance, sell or pay off early, favor the offer with the smaller upfront fee. Confirm there is no prepayment penalty either way; the loan agreement has to say so.

Mortgage shoppers get help here. Page 3 of the Loan Estimate has an “In 5 Years” line showing what you would have paid, and how much principal you would have paid off, in the first five years. That figure is often a better comparison than the APR if you might move.

Discount points are a different charge

Discount points are prepaid interest: you pay the lender a lump sum at closing in exchange for a lower interest rate for the life of the loan. One point costs 1% of the loan amount. An origination fee buys no rate reduction at all; it pays the lender for setting up the loan. Both count in the APR, and on the Loan Estimate both sit in Section A, Origination Charges, but on separate lines: points appear first as “% of Loan Amount (Points),” and fees such as application or underwriting charges are listed below.

Whether points pay off depends on how long you keep the mortgage. Say you borrow $300,000 over 30 years, and one point ($3,000) would cut your rate from 7% to 6.75% in this example. The payment drops from $1,995.91 to $1,945.79, a saving of $50.12 a month, so you need about 60 months to recover the $3,000. Sell or refinance before five years and the point cost you money; stay longer and it saved you money. Ask each lender for the rate with and without points, since the reduction one point buys varies.

Where the APR works differently

• Credit cards. For a card, the APR is the interest rate: Regulation Z defines it as the periodic rate times the number of periods in a year. Annual fees are excluded from the finance charge, so they never show up in a card’s APR. How that rate turns into a monthly charge is covered in how credit card interest is calculated.
• Mortgages. Some closing costs are left out of the APR by rule. Fees for title examination, document preparation, notary services, appraisals and escrow amounts on real estate loans are excluded if they are bona fide and reasonable, so compare the full closing cost totals too.
• Adjustable rates. The APR on an adjustable-rate loan is calculated as if the index stays where it is at closing. It cannot predict future rates, so look at the caps and the maximum payment the disclosure shows.

For personal loans specifically, the rest of the offer, from the term to the payoff, is laid out in how a personal loan works.