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What Is Personal Loan Annual Percentage Rate (APR) and How Does it Work?

| MoneyRates Personal Finance Specialist.
min read

couple-comparing-loansPersonal loan providers must by law disclose their product's APR, or annual percentage rate, when they make you an offer. That's because APR is about more than the interest rate - it also includes the loan's cost. The personal loan APR helps you compare loan offers. This is true even when the loans have different interest rates and costs.

What are today's personal loan interest rates?

What Is Annual Percentage Rate, or APR?

APR is a government-mandated calculation that includes the loan's costs and its interest rate. Here's how it works:

Loan offers or advertisements typically contain interest rates. These advertised or "stated" rates don't usually reflect the entire cost of the loan. For this reason, the government requires any that an advertisement or offer containing a stated interest rate must also disclose the annual percentage rate, or APR.

  • The stated rate is what lenders use to determine your monthly payment
  • The APR reflects the actual cost of the loan

Lenders must disclose the loan's APR in type at least as large as the type they use for the stated interest rate. The purpose of this disclosure is to make it easier for consumers to compare loans with different interest rates and costs.

How Does APR Work on a Loan?

APR calculations operate on the principle that if you have to pay fees to borrow money, you're not really getting the entire loan proceeds. Even though your monthly payment is based on the entire loan amount.

Here's a look at APR in action. You can use MoneyRates APR calculator to follow along and see for yourself how it works.

If you borrow $10,000 for 15 years at a 7% interest rate and there are no lender fees or costs, your APR is 7%.

But what if the loan fees are $500? The 7% interest doesn't reflect the entire cost of the loan. That's where APR comes in.

The monthly payment for a $10,000 15-year loan at 7% is $89.88. But if your loan fees are $500, you're actually only getting $9,500 of your $10,000 loan. And if your payment is $89.88 and your loan proceeds are $9,500, the interest rate you're paying is really 7.79%.

Related: What Are Personal Loans, Unsecured Loans and Signature Loans?

How Do You Use APR to Shop for Personal Loans?

When you shop for a personal loan, you'll compare a variety of terms - loan length, interest rate and lender costs. And if you only look at the interest rate, you could end up paying more than you need to. You need to consider the APR.

Here's an example of how using the APR when shopping for a personal loan could save you money. Suppose that you need to borrow $10,000 for 15 years and you get two offers. One has an interest rate of 6% and requires no fees. The other has a 5.5% rate and costs $1,000. If you just choose the loan with the lowest rate, you'd probably be making a mistake. The APR of the more expensive loan is actually 7%!

Should You Always Choose the Loan With the Lowest APR?

Many financial writers recommend choosing the loan with the lowest APR when shopping for personal loans. But it isn't entirely cut-and-dried. Sometimes you need a lower rate and payment to qualify for the loan you want. That may involve paying fees, even if the APR is higher.

And sometimes, paying upfront fees might be a mistake, even if the APR is lower. For example, choosing a loan with a higher rate and lower fees makes sense if:

  • You earn more by investing that money than you'd get back by reducing your loan payment
  • You could be using that money to pay off other debt with higher interest rates
  • You'd be depleting your emergency fund by paying for a lower personal loan interest rate
  • You plan to pay off the loan early. You won't get the full benefit of "buying down" your interest rate

Personal loan providers offer a wide range of personal loans at different price points. Some have no fees at all, while others may charge up to 6% of the loan amount.

Related: Personal Loan Interest Rates (How to Pay Less)

Personal Loan APR Mistakes to Avoid

Using APR to shop for a personal loan can make it easier to compare offers. But only if you avoid common mistakes.

  • Don't compare loans with different terms. Upfront costs are spread over the entire term of the loan. The loan in the example above with a 7% APR and a 15-year term has a 6.69% APR when you increase the term to 20 years. So only compare APRs of loans with the same terms.
  • Don't rely on APR when the interest rate is variable. Most personal loans have fixed interest rates, but some products have variable interest rates. When the rate is variable, the APR relies on assumptions about the economy that are difficult to predict and unlikely to unfold exactly as disclosed.
  • Recalculate the APR (or ask the lender for a new disclosure) if your loan amount changes. A standard $500 fee produces a very different APR for a $15,000 loan than it does a $10,000 loan.

Lender have to give you APR information by law. But it's up to you to use it wisely.

Breakeven

If you pay upfront costs to have a lower interest rate and payment, it takes time for the lower payment to offset the money you pay upfront. That time is called a "breakeven period." This is important if you believe there is a good chance that you'll be paying your loan off early.

For instance, if you pay $1,000 upfront to save $25 a month, it will take 40 months (40 * $50) to recoup the upfront cost of the lower rate. If your loan term is only three years (36 months), it clearly makes no sense to buy the rate down. If it's a five-year loan (60 months), you break even in 40 months and enjoy 20 months of saving $25. That can be a good thing if you hold the loan for its full term.

Don't put off zeroing out your balance just to break even on your costs, though. Those upfront costs are sunk, and it's always cheaper to pay off a loan faster if you can afford to do so.

Related: Personal Loans vs Credit Cards (Everything You Need to Know)

Is There an Easier Way to Compare Personal Loan Costs?

You don't need to know how to calculate the APR on a loan. There actually is an easier way to compare personal loan costs. And you don't need a finance degree - just a plain calculator, spreadsheet or pencil and paper. This method also allows you to compare the cost of loans with different terms.

You'll look at three things:

  • Loan term (months)
  • Monthly payment
  • Upfront loan costs

For each loan, simply multiply the monthly payment by the number of months in the loan term. Next, add the upfront loan costs. And finally, subtract the loan amount. The difference is what it costs you to borrow.

The chart below shows how you might compare two loans.

Loan ALoan B
Loan Amount$ 10,000$ 10,000
Lender Fees$ 500$ -
Rate

6%

7%

Payment

$193.33

$198.01

Term (Months)

60

60

Total Payments

$11,600

$11,881

Total Payments and Fees

$12,100

$11,881

Total Financing Costs

$2,100

$1,881

The idea behind the APR is to express a loan's financing costs as an interest rate and (supposedly) make shopping for financing easier. However, APR can be tricky. Sometimes, it makes more sense to express loan costs in plain old dollars.

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