When the interest rate and annual percentage rate (APR) are calculated for a loan—especially a large one—the two can produce very different numbers, so it’s important to know the difference when evaluating what a loan will cost you.
Basically, the interest rate is the cost for borrowing money, and the APR is the total cost, including lender fees and any other charges.
Let’s look at interest rates vs. APRs for loans, and student loans in particular.
What Is an Interest Rate?
An interest rate is the rate you pay to borrow money, expressed as a percentage of the principal. Generally, an interest rate is determined by market factors, your credit score and financial profile, and the loan’s repayment terms, among other things.
Nearly all federal student loans have a fixed interest rate that is not determined by credit score or financial standing. (A credit check is made for federal Direct PLUS Loans, which reject applicants with adverse credit, except in specific circumstances.)
Rates on federal student loans are rising: For loans made from July 1, 2021, to June 30, 2022, rates are increasing by nearly 1 percentage point:
• Direct Loans for undergraduate students. 3.734%, up from 2.75% for 2020-21.
• Direct Loans for graduate students. 5.284%, up from 4.3% in 2020-21.
• Direct PLUS Loans. 6.284%, up from 5.3% in 2020-21.
If a loan were to have no other fees, hidden or otherwise, the interest rate and APR could be the same number. But because most loans have fees, the numbers are usually different.
What Is APR?
An APR is the total cost of the loan, including fees, expressed as an annual percentage.
Compared with a basic interest rate, an APR provides borrowers with a more comprehensive picture of the total costs of paying back a loan.
The federal Truth in Lending Act requires lenders to disclose a loan’s APR when they advertise its interest rate.
In most circumstances, the APR will be higher than the interest rate. If it’s not, it’s generally because of some sort of rebate offered by the lender. If you notice this type of discrepancy, ask the lender to explain.
APR vs. Interest Rate Calculation
The bottom line: The interest rate percentage and the APR will be different if there are fees (like origination fees) associated with your loan.
Let’s say you’re comparing loans with similar interest rates. By looking at the APR, you should be able to see which loan may be more cost-effective, because typically the loan with the lowest APR will be the loan with the lowest added costs.
So when comparing apples to apples, with the same loan type and term, APR may be helpful. But lenders don’t always make it easy to tell which loan is an apple and which is a pear. To find the best deal, you need to seek out all the costs attached to the loan.
You may find that a low APR comes with higher upfront fees, or that you don’t qualify for a super low advertised APR, reserved for those with stellar credit.
How APR Works on Student Loans
Not all students (and graduates, for that matter) understand the true cost of their student loans. Borrowers may think that only private student loans come with origination fees, but that is not the case.
Most federal student loans have loan fees that are taken directly out of the balance of the loan before the loan is dispersed. It’s on the borrower to pay back the entire amount of the loan, not just the amount received at disbursement.
Federal student loan fees from Oct. 1, 2020, to Oct. 1, 2022, are as follows:
• Direct Subsidized and Direct Unsubsidized loans. 1.057% of the total loan amount
• Direct PLUS Loans. 4.228% of the total loan amount
While interest on many other loans is actually calculated monthly or annually, interest on federal Direct Loans is calculated daily. As a result, it is slightly more difficult to do an interest rate-to-APR calculation on a federal student loan.
An online calculator can help you discover the APR on a loan after you provide the loan amount, interest rate, loan fees, and repayment term in years.
Consider a $10,000 Direct PLUS Loan at 6.284%. With a 4.228% loan fee (about $423) that a borrower pays back over 10 years, the loan’s APR is about 7.2%.
Comparing Private and Federal Student Loans
Federal and private student loans have their pros and cons. In general, Direct Subsidized Loans offer competitive rates that are not dependent on the borrower’s credit.
When a federal student loan is subsidized, the borrower is not responsible for paying the interest that accrues while the student is in school and during most deferment periods.
Additionally, federal student loans offer flexible repayment plans, including income-driven repayment options.
Federal student loans have fixed rates, and private loans may have fixed or variable rates.
Private student loans typically take borrowers’ credit into consideration. They can be useful in bridging gaps in need if you reach a cap on federal student loan borrowing.
Understanding Interest Costs
Being able to compare an APR to another APR may help level the playing field when shopping for loans, but it’s not the only thing to consider.
You might want to take into consideration the repayment period of the loan in question, because it will also affect the total amount you’ll owe in interest over the life of the loan.
Two loans could have the exact same APR, but if one loan has a term of 10 years and the other has a term of 20 years, you’ll pay more in interest on the 20-year loan even though your monthly payments may be lower.
To illustrate this, imagine two $10,000 loans, each at a 7% interest rate, but with 10- and 20-year repayment terms.
$116.11 monthly payment
Total interest paid: $3,933
$77.53 monthly payment
Total interest paid: $8,607
As you can see, the monthly payment on the 20-year loan is lower, but you pay significantly more in interest over time.
The reverse is also true: Shortening the payback period should lower the amount that you pay in interest over time, all else being equal.
Can Refinancing Help?
When you refinance student loans, you pay off your existing federal and/or private student loans with a new loan from a private lender, aiming for a lower interest rate or a repayment timeline that works better for your finances.
A brand-new loan means dealing with only one monthly payment.
Refinancing may be a good idea for working graduates who have high-interest Unsubsidized Direct Loans, Graduate PLUS loans, and/or private loans. Just realize that when borrowers refinance federal student loans, they give up benefits like income-driven repayment plans and loan forgiveness.
To understand how interest rates, loan repayment terms, and total interest charges interplay with one another, check out this student loan refinancing calculator.
APR vs. interest rate: It’s not the next superhero movie. It’s what you may want to look at when deciding on a loan, because the APR reflects the fees involved. Even when it comes to federal student loans, fees are part of the story.
SoFi offers student loan refinancing with flexible terms and low fixed or variable rates, with absolutely no application or origination fees.
SoFi Student Loan Refinance
If you are looking to refinance federal student loans, please be aware that the White House has announced up to $20,000 of student loan forgiveness for Pell Grant recipients and $10,000 for qualifying borrowers whose student loans are federally held. Additionally, the federal student loan payment pause and interest holiday has been extended beyond December 31, 2022. Please carefully consider these changes before refinancing federally held loans with SoFi, since the amount or portion of your federal student debt that you refinance will no longer qualify for the federal loan payment suspension, interest waiver, or any other current or future benefits applicable to federal loans. If you qualify for federal student loan forgiveness and still wish to refinance, leave unrefinanced the amount you expect to be forgiven to receive your federal benefit.
CLICK HERE for more information.
Notice: SoFi refinance loans are private loans and do not have the same repayment options that the federal loan program offers such as Income-Driven Repayment plans, including Income-Contingent Repayment or PAYE. SoFi always recommends that you consult a qualified financial advisor to discuss what is best for your unique situation.
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