Understand the difference between Annual Percentage Rate (APR) and Interest Rate
You earn interest on money that you invest and you pay interest on money that you borrow. This is essentially the main difference between APR (annual percentage rate) and interest rate. When you put money into your savings account, purchase bonds or invest it in some other way so that interest is paid on the money, you earn extra money. Even though the rate may not be high, this is what is referred to as the interest rate.
When you take out a loan or carry a balance on your credit card the company or financial institution charges you money for the privilege of borrowing. This is also interest, but it is referred to as APR. The amount of money you pay depends on the percentage charged and it is adjusted on an annual basis.
The amount of money that you borrow or invest is called the principal (P). In the case of a loan, this is the money you have to repay. The principal in an investment is the amount of money you put into the plan or the account. The money that you pay or earn on the principal is the interest (I). The way in which the interest is calculated depends on the rate (r) or percentage set out by the financial institution that you deal with. Both the interest rate and the APR are set at various times throughout the year but they are only changed on individual accounts once a year.
There are two types of interest and they are calculated differently. Simple interest is the money that is paid or charged on the principal only. It is not paid on the interest that the money earns. It is also known as flat rate interest. In the case of a loan, the amount of interest is added to the principal at the time of borrowing and there are no extra monthly charges involved.
Compound interest refers to interest that is paid or charged on the principal plus any money earned in interest in the previous month or year.
The annual percentage rate refers to the rate of interest that a lender will charge on the money borrowed. There are different APR’s for different people depending on the amount of money they borrow and their credit rating. It also depends on the term of the loan. There are different ways of calculating the amount of interest you pay over the course of the repayment, but generally it is the APR multiplied by the amount borrowed and this is compounded monthly. This means that the amount of interest decreases each month because you owe less money.
The interest rate is set by the central bank of a state or country and is fixed for a period of time.