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No one wants to pay more than they need to on a mortgage loan or refinance. That’s why it’s important to understand the difference between annual percentage rate (APR) and interest rate.
Interest rate is like a pizza—minus all the fixings. It’s shown as a percentage and gives you a way to gauge your monthly costs. APR, on the other hand, is the yearly cost of a loan. It’s also shown as a percentage, but it includes all the fixings such as mortgage insurance, discount points, origination fees, mortgage broker fees, and some closing costs. In that way, APR actually gives you a much clearer idea of what you’re paying.
For example, you might find a 4.5% interest rate on a mortgage rate, but once you add in all the extra fees, the APR becomes 4.6% or 4.7%.
The Truth in Lending Act (TILA), enacted in 1968 by the federal government, requires lenders to divulge credit terms easily understood for the borrower. That way, consumers can comparison shop rates and determine the affordability of a loan. It puts you in charge and gives you the leverage to make more informed decisions.
So why do lenders advertise both an APR and an interest rate? Which one should you pay attention to?
APR vs. Interest Rate: What’s the Difference?
Consumers use both APR and the interest rate to determine the cost and affordability of a loan.
Interest Rate Defined
Interest rates are typically determined by a borrower’s credit score and prevailing rates–i.e., the average interest rate currently charged on mortgage loans by lenders. Your monthly payment is based on the principal balance and interest rate, not the APR. Your interest rate is usually based on your credit score, so the higher your credit score, the better your interest rate. The interest rate is only the interest paid to the lender.
Mason Miranda, a credit industry specialist with Credit Card Insider, located in Syracuse, New York, defines interest rate this way: “An interest rate is a charge for borrowing a principal loan amount over a period of time is always expressed as a percentage. It can be variable, with the possibility of changing over the life of the loan, or fixed, which it means will stay the same over the life of the loan.”
Today, as you and millions of other Americans grapple with the realities of COVID-19, mortgage interest rates have dropped, offering a bit of good news for prospective homebuyers and current homeowners who want to cash in on these low rates by refinancing.
When comparing lenders, pay attention to the APR, which is the real cost of financing.
APR is fixed by the lender and includes lender fees and other costs that vary from one lending institution to the next. It gives borrowers a more realistic picture of what a loan will cost them. APR is not related to your monthly payment, which is calculated using only the interest rate.
“APR is broader and typically a bit higher because it is the annual cost of the loan to the borrower including fees and one-time costs like mortgage insurance, closing costs, loan origination fees, broker fees, etc.,” says Michael Foguth, founder of Foguth Financial Group, a financial planning agency in Michigan. “The APR is required by law to be disclosed on the loan agreement. Your monthly payment, however, is based on the interest rate on your loan.”
APR should be used when comparing total costs of loans, Foguth says.
Keep in mind, though, that the APR may not include every fee, such as appraisal, inspection and credit reporting fees. When comparison shopping, it’s always a good idea to ask your lender what is and what is not included in the APR they quote so you have an accurate picture of all the costs of buying a home.
Interest Rate vs. APR in Dollars
A mortgage calculator helps you as a prospective borrower calculate the overall costs–with interest and APR– of a loan. In the example below, you can see the actual dollar difference between interest and APR on a $250,000 loan whether a 30-year or 15-year fixed term. Note that 15-year loans charge less interest because you’re paying off the balance in a shorter time frame.
|Loan Type||Interest Rate||APR||Overall Cost of Loan with Interest($250,000)||Overall Cost of Loan with APR($250,000)||Difference: APR Vs. Interest Rate($250,000 Loan)|
|30-Year Fixed Rate||3.250%||3.530%||$391,689.45||$405,872.41||$14,182.96|
|15-Year Fixed Rate||2.750%||3.070%||$305,403.25||$312,321.52||$6,918.27|
*Rates above based on NextAdvisor’s June 2020 rates
Shopping Rates: Buyer Beware
Many lenders advertise deceptively low interest rates on mortgages to draw you in. The rates may be tempting, but many don’t disclose the true loan terms as the law requires.
When shopping for a mortgage, pay attention to the interest rate, as it’s what lenders use to calculate your monthly payment. But mortgage lenders are also required to disclose the APR because it measures the total cost of the loan, something interest rates don’t take into account.
“A really good way to compare different mortgages – which is always recommended so you can feel confident in making the right pick – is by comparing the APR on each loan estimate you receive,” says Andrina Valdes, COO of Cornerstone Home Lending, a San Antonio home lending company.
“It’s really easy to mix up an APR and a loan’s interest rate since they look to be similar,” says Valdes. “It’s also important to note if the APR is a lot higher than the mortgage interest rate on a mortgage, it could be a red flag that too many fees are being charged. For example, one lender may advertise an origination fee of 1%, so on a $250,000 loan—the fee would be $2,500.”