APR Vs. Interest Rate: Learn The Key Differences
Have you always thought APR and interest rates are the same thing? If so, you’re not alone.
The key difference between APR and interest rate is that APR encompasses all costs associated with getting a mortgage, including interest and various additional lender fees like closing costs and origination fees. Interest rate, also expressed as a percentage, is simply the baseline cost a lender charges to loan you money, and you’ll pay interest each month as part of your mortgage.
Knowing the difference between interest rate and APR is essential when shopping for a mortgage. Follow along to learn more about APR vs interest rate and which to consider when searching for the best deal.
What Is Interest Rate?
The interest rate, or nominal rate, on a mortgage is the expense of borrowing from a lender. Interest rate is expressed as a percentage and may be fixed or variable, depending on the type of mortgage you choose.
You can calculate your interest payments by multiplying your loan amount by your interest rate. For example, if you take out a $160,000 fixed-rate mortgage with a 4% interest rate, then you’ll pay $6,400 in total interest – or $533.33 per month – during the first year. This is the principal and interest payment and does not include taxes and insurance.
What Is APR?
APR, or annual percentage rate, is a little more complex because 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.
The Key Differences Between APR And Interest Rate
The key differences between APR and interest rate involve how broadly they represent your monthly payments and who controls how the rates change. Interest rates are largely determined by market trends and economic conditions outside of the lender’s control. However, you can lower your interest rate by improving your financial metrics, like your credit score and debt-to-income ratio (DTI). Since APR includes fees set by the lender, they have much more power to influence your APR. When shopping for a mortgage loan, remember these key considerations for the two metrics:
- Gives a broader view of what you will pay for upfront and recurring mortgage fees, including interest and origination fees
- Determined by the lender
- Provides a more helpful way to compare the overall cost of a mortgage loan between lenders
- A loan’s APR will almost always be equal to or greater than the same loan’s interest rate
- Only tells you what you will pay in interest, not any other fees
- Determined by economic conditions and your financial situation
- Does not represent the total costs of a mortgage loan
- A loan’s interest rate will almost always be equal to or less than the same loan’s APR
It’s important to note that APR is not used for compound interest, which is interest that “compounds” or builds exponentially on existing interest. Lenders typically use annual percentage yield (APY) for borrowing that involves compound interest, such as credit cards.
How Is Interest Rate Calculated?
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. However, you can control your personal financial health, most importantly, your credit score. 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.
For another example, if you take out a $400,000 loan with a 7% interest rate, you’d pay $28,000 per year, or $2,333.33 per month, in interest. However, this does not include your monthly mortgage insurance payment, your upfront closing costs or taxes and insurance, so it’s not a full representation of the costs of a mortgage loan.
How Is APR Calculated?
To continue with the previous example, let’s say you pay $12,000 in closing costs and $3,000 in origination fees for a $400,000 loan. To calculate your APR, add these fees to the loan amount to get a total of $415,000 and multiply that by your interest rate of 7%. Take this number, $29,050, and divide it by the original loan amount of $400,000 to get your final APR of 7.26%. The equation can also be seen as follows:
APR=((Loan amount + fees)*Interest Rate)/Loan Amount
APR is ultimately set by individual lenders because 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. Some lenders may offer 0% APR, but these discount deals are often only for a limited time before you must start making payments on the loan. There also may still be upfront payments for the loan, so it is essential to read and understand the terms of your loan before signing.
Without APR, it would be much more difficult to assess the true total 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 of what a borrower can expect to pay.
When To Use APR Vs. When To Use Interest Rate
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. However, how long you’ll be in the home can affect which metric to consider.
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.
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 difference between APR versus interest rate is vital to understand for any home buyer. Generally, APR is a better metric to use when comparing loans because it represents a broader view of the total cost of the loan, while interest rates only represent the amount you will pay in interest payments. If you’re ready to apply for a mortgage and compare the difference between interest rate and APR today.