Nominal Rate vs. APR vs. APY
These three terms are often used loosely but mean different things. The nominal rate is the stated annual rate before compounding. APR (Annual Percentage Rate) includes certain fees and reflects the true yearly cost of borrowing, but still doesn't account for compounding within the year. APY (Annual Percentage Yield) does account for compounding, which is why a savings account advertising a rate "compounded monthly" will have a slightly higher APY than its nominal rate.
Why the Distinction Matters When Comparing Offers
Two loans with the same nominal rate can have different real costs if one compounds more frequently or carries additional origination fees rolled into the APR. Comparing APR to APR — rather than advertised rate to advertised rate — is the more reliable way to evaluate competing loan offers.
How Lenders Set Interest Rates
Rates are generally built from a base rate (often tied to a central bank's benchmark rate) plus a margin that reflects the borrower's credit risk, the loan type, and the term length. Shorter loans and borrowers with stronger credit typically qualify for lower rates, since the lender is taking on less risk of default or of the money losing value before it's repaid.
Fixed vs. Variable Rates
A fixed rate stays the same for the life of the loan, giving predictable payments. A variable rate moves with a reference index, which can mean lower payments when rates fall but higher payments — sometimes significantly — when rates rise. The right choice depends on how much payment uncertainty a borrower is willing to accept in exchange for a potentially lower starting rate.