APR Vs. Interest Rate: Learn The Difference
If you’re shopping for a mortgage or want to refinance, you’ve probably encountered two related but distinct terms: “interest rate” and “annual percentage rate” (APR). Both have implications for the cost of your mortgage, but interest rate and APR are not synonymous.
Let’s take a deeper look into both types of rates – and how understanding the difference between your APR versus your interest rate is crucial to finding the best deal on your mortgage.
What Is The Difference Between Interest Rate And APR?
Though both reflect how much you’ll pay when you take out a mortgage, interest rate and APR differ in the costs they consider. Whereas interest rate refers only to the base cost of borrowing the principal on a loan, APR includes both the interest rate and associated fees, such as closing costs, broker fees and discount points.
APR and interest rates are both represented as percentages, but because APR covers expenses plus the mortgage rate, you should expect to see a higher APR compared to the loan’s interest rate.
Both percentages can help you compare lenders and determine what’s in your price range. Let’s break down these terms further.
Interest Rate Defined
The interest rate, or nominal rate, on a mortgage is the yearly interest expense incurred by the borrower. Interest rate is expressed as a percentage and may be fixed or variable, depending on the type of mortgage you choose.
For example, if you take out a $160,000 fixed-rate mortgage with 4% interest, then you’ll pay $6,400 in total interest – or $533.33 per month – during the first year.
As you pay down your principal balance, your interest rate and monthly payments will remain the same, but a smaller chunk of your payment will go toward interest. Instead, a larger portion of your payment will go toward principal, which means you’ll gradually increase your equity in the home.
How Interest Rate Is Determined
The interest rate on a mortgage will depend on market trends, as well as the federal lending rate set by the U.S. Federal Reserve. This factor is largely out of your control, except in the sense that savvy home buyers might try to time their purchase so as to lock in a mortgage rate when the market is favorable to borrowers – in other words, when interest rates are low.
The interest rate you get on a mortgage will also depend on your personal financial health, most importantly your credit score. Unlike market trends, you do have the ability to improve your credit. And because a higher credit score could lead to a lower interest rate (and serious money saved over the life of the loan), it’s a good idea to get your credit in shape before applying for a mortgage.
If you’re unsure how to build up your credit, you can start by making credit card payments on time, catching up on any late bills and avoiding high balances on your credit accounts.
APR, or annual percentage rate, is a little more complex in that it reflects both your interest rate and any additional costs associated with the mortgage, including lender fees. These additional costs could include:
- Origination fees
- Prepaid interest
- Mortgage discount points
- Broker fees
- Private mortgage insurance (PMI)
- Closing costs
Because APR includes additional costs, it’s typically a higher percentage than the nominal interest rate.
It’s important to note that APR is not used for compound interest, which is interest that “compounds” or builds exponentially on existing interest. Since compound interest is typically used on investment, a different metric is used: annual percentage yield (APY).
How APR Is Determined
It’s important to remember that, unlike interest rates, APR is set by individual lenders in the sense that they choose how much to charge for additional fees on top of the interest rate. For example, some lenders charge more for closing fees than others. As a result, two lenders offering the same nominal interest rate might actually offer different APRs.
Because APR rolls variable costs and fees into a single figure, it’s often a more useful way to compare mortgages than interest rates. Essentially, without APR, it would be much more difficult to assess the true cost of a loan, because borrowers would have to manually calculate fees and APR. Fortunately, the Truth in Lending Act of 1968 requires lenders to disclose APR to borrowers. This ensures greater transparency in lending – and a clearer sense for what a borrower can expect to pay.
Using APR And Interest Rate To Find A Mortgage
Both APR and interest rate are useful tools for finding the best mortgage for your borrowing needs. For most home buyers, it’s generally better to use APR than interest rate when shopping for a mortgage. That’s because APR more completely and accurately represents the total cost of the mortgage over the full life of the loan.
Not sure what that looks like in practice? Let’s look at an example.
Suppose Lender A offers an interest rate of 3.9%, while Lender B offers an interest rate of 4.0%. It may seem like an obvious decision to go with Lender A, right? Not so fast! In order to understand the true cost of the mortgage over time, you’d need to know what both lenders are charging for broker fees, closing costs and other lender fees – all of which factor into the APR. If both lenders charge the same fees, but Lender A also requires the purchase of two discount points to get the lower nominal interest rate, you might ultimately be better off with Lender B.
There’s a flipside to this as well. If a lender charges expensive fees in exchange for a lower interest rate than their competitors, you might still choose that lender if it means getting a better APR overall.
No matter what, when shopping for a lender, you should make sure you’re comparing like products. You wouldn’t want to compare a 15-year mortgage from Lender A to a 30-year mortgage from Lender B. The same goes for fixed-rate and adjustable-rate mortgages: Always compare like with like.
A Note On APR And Short-Term Homeownership
If you're certain that you're purchasing your forever home, it makes sense to shop around and choose a mortgage with the lowest APR and more upfront fees because, ultimately, you’ll pay less to finance your house in the long run.
However, if you don’t plan on staying in the home for the long haul, it may make more sense to choose a loan with a higher rate, fewer upfront fees and a higher APR, because you'll end up paying less during the first few years of the mortgage.
The Bottom Line
The differences between APR and interest rate are subtle, but they could have a profound effect on the total cost of a mortgage. Even a small fraction of a percentage could result in significant expenses – or savings.
If you plan to own your home for the long haul, you’re probably better off using APR when shopping for a mortgage. If you plan to sell after a short period of time, you’ll have a slightly more complex decision to make.
Ready to explore interest rates and APRs for your next home purchase or refinance? Get started online today.