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Taking out a personal loan? Hold up. Before you sign your loan agreement and begin counting your cash, do your homework to find out exactly how much that loan will cost you.
Two major factors in the repayment of your loan are the annual percentage rate, or APR, and the interest rate. And these two figures are not always created equal.
We will breakdown what these numbers mean when you take out a loan and how to get the best rate possible.
What’s the Difference Between the Interest Rate and APR?
The interest rate is the cost of borrowing money. Your lender is charging you to borrow its money until you pay them back in full. Almost all types of loans have some kind of interest rate.
The APR includes any fees and points that may be tacked onto your loan in addition to the interest rate. Fees can include an “origination fee” that ranges from 1 to 8% to cover the cost of processing your loan. Points are typically a percentage of your loan — 1% of the loan equals 1 point, for example — and lenders will offer you a lower rate if you agree to pay these points upfront. Points are often seen in mortgage loans, but can also pop up in personal loans.
How Much Will I Pay in Interest and APR?
There are some loans in which the interest rate and the APR are the same, meaning there is no cost difference between the two rates. But it’s always important to read the fine print.
Let’s take a $10,000 personal loan that you plan to pay back within five years. If you get a 5% interest rate and no further fees, your interest rate and APR are the same at 5% and you will pay back a total of $11,322.74 with interest over the life of the loan.
If you are offered the same $10,000 loan, with a lower 4.5% interest rate, but also a $200 financing fee, are you getting a better deal? Your APR would actually be 5.31% (higher than the first offer) if the payment was amortized over the life of the loan, and the total cost of the loan would be $11,409.53 over the next five years. If you pay the fee upfront, rather than over the lifetime of the loan, you will still pay $11,385.81 in total for this loan. Even if the advertised interest rate on one loan appears to be lower than the others, you should compare the APRs disclosed by the lenders to make sure you are still getting the best overall terms since all lenders are required to calculate the APR the same way.
Make sure to ask your lender about the APR, points and financing fees before you sign. This calculator can help you figure out how much you’d pay based on the proposed loan terms.
What Are Some Pitfalls to Watch out For?
Look for a lender that does not require you to pay a hefty fee tacked on to your loan. But also consider the interest rate and the APR to get the whole picture. If the lender charges fees but has a much lower interest rate and APR than you can get elsewhere, it may be worth it for you to pay the fees to get a lower rate.
Shop around for the best interest rates and APR. Consider online lenders and brick and mortar lenders. Your lender should make you feel comfortable and informed about your loan agreement. Take your time to read the terms of your loan and ask questions.