What Is an Annual Percentage Rate on a Personal Loan?

Loans, Personal Loans
What is an Annual Percentage Rate on a Personal Loan?

The term “annual percentage rate” is commonly used in reference to financial products such as mortgages, credit cards and personal loans.

Broadly speaking, APR is the sum of the interest rate plus extra fees, also known as finance charges, calculated on a yearly basis and expressed as a percentage. If there are no fees, the APR equals the interest rate.

For personal loans, the APR is a function of the amount borrowed, the duration of the loan and the fees charged.

Why APRs are important for personal loans

When you’re shopping for a credit card or loan, the APR is one of the most important things to consider because it provides an apples-to-apples cost comparison. The interest rate or monthly payment alone do not reflect the true cost of the product.

Personal loans are fixed-rate installment loans, which means your interest rate won’t change over the term of the loan and you pay the loan back in equal, monthly installments. Lenders assign an interest rate based on your credit score, credit report and the ratio of your debt to gross income.

Personal loans usually come with an upfront fee — the origination fee — that ranges between 1% and 6% of the loan amount. The fee you’re charged also depends on your credit profile.

It pays to shop around at multiple lenders, because each lender uses a different formula to calculate APR. Most online lenders let you check your estimated rate without affecting your credit score.

Let’s look at how APR helps you choose a loan. Assume you want to borrow $5,000 and pay it back over four years. You apply at two lenders and are quoted the following rates:

 Lender 1Lender 2
Interest rate10%11%
Origination fee$150 (3% fee)$100 (2% fee)
Monthly payment$131$132
APR11.6%12.1%

At first glance, it’s hard to know which loan is cheaper. One lender offers a lower interest rate but charges a higher fee. The monthly payment is almost equal.

That’s when APR comes in: The first loan has an APR of 11.6% and the second loan has an APR of 12.1%, making the first loan the less expensive option overall.

Now you can confidently compare the total cost of both loans and choose the one that’s right for you. NerdWallet recommends choosing the loan with the lowest APR for a given loan term, because it’s always the cheapest option.

In some cases, it can make sense to choose the higher-interest-rate loan — if the monthly payment is more affordable for your budget, for instance, or if the origination fee is lower. Some lenders deduct this fee upfront, so even if you’re approved for a $5,000 loan, you may end up getting less than that amount.

APRs for credit cards and mortgages

APR calculations follow a complex mathematical formula that depends on the financial product. Mortgage APRs and credit card APRs are more nuanced than those for personal loans. Mortgage APRs include closing costs and other fees. Credit cards don’t have upfront fees, so the interest rate and APR are the same, but they also have more than one kind of APR.

» MORE: How does APR affect your mortgage?

Financial companies in the U.S. are required by law to provide consumers the APR of a product as part of a loan agreement or a credit card account agreement.

more:

What’s a good rate on a personal loan?

Compare personal loans without affecting your credit

How to get the best mortgage rate

Amrita Jayakumar is a staff writer at NerdWallet, a personal finance website. Email: ajayakumar@nerdwallet.com. Twitter: @ajbombay.