Annual Percentage Rate (APR) vs. Interest Rate: What’s the Difference?

Annual Percentage Rate (APR) and interest rate are two important metrics that affect the cost of borrowing money. Although the two figures are related, it is important to know the difference between interest rates and APRs when comparing mortgage offers. For example, knowing how the APR is calculated can save you thousands of dollars on your home loan.

APR vs interest rate gets confusing as some people use the terms interchangeably. In addition, some mortgage lenders prominently display their loan interest rates – usually because the interest rates are lower than the annual percentage rate. So generally, you need to find the APR in the small print of the loan terms.

What’s the Deal With Interest Rates and APR Calculations? How can you interpret these figures to determine the true cost of your mortgage? What is a good APR for a loan when comparing mortgage rates?

This article helps you learn how to compare lender fees to get the best deal on your mortgage.

What is the interest rate?

An interest rate is the amount a lender charges you to borrow money. It is expressed as a percentage and represents the additional fee that you will have to pay over and above the principal loan amount. Depending on the loan type, the interest rate may be fixed for a period or a variable rate that changes with market conditions.

When you borrow money in the form of a personal loan, mortgage or credit card, you must repay an initial amount (your principal). Then, annual interest is added, increasing the final amount you must pay the lender.

There are two types of basic interest rates – adjustable and fixed:

• Fixed Mortgage Interest Rate: This type does not change for a specific period, usually between one and ten years. This fixed-rate mortgage is less risky and easier for borrowers to calculate future mortgage payments. The monthly principal and interest rates remain fixed.
• Adjustable-rate mortgage (ARM): A mortgage with a variable rate usually has a lower initial interest rate for a specific term. However, adjustable-rate loan interest rates can increase or decrease based on changes in the benchmark rate. Generally, it takes more work to predict the future costs of financing with monthly repayments. As a result, mortgage payments will change over time.

Connected, A guide to interest rates.

how to calculate interest rate

To calculate the annual cost of borrowing money based on the interest rate, add the percentage rate to the amount you borrow. However, several factors affect the interest rate offered by the lender. These factors include market rates, inflation and economic conditions.

Lenders also assess your financial profile while calculating the interest rate for the home loan. For example, they consider your debt-to-income ratio, credit score, and down payment amount. Anything you can do to boost your credit score will help you secure lower interest rates.

In addition to market rate changes — over which you have no control — you can influence the interest rate by reducing credit card balances and improving your credit history.

However, using only the interest rate doesn’t allow you to calculate the total cost of the mortgage payment. Mortgages come with additional costs. These may include annual mortgage insurance, origination fees, discount points and closing fees. Additionally, the amount of the down payment can significantly affect the interest rate. Therefore, knowing the annual percentage rate is involved in comparison to the final cost of the mortgage.

Connected, The Ultimate Guide to Home Loans.

What is Annual Percentage Rate (APR)

APR stands for Annual Percentage Rate. APR represents a more accurate mortgage, personal loan or credit card borrowing cost. This is called the “effective interest rate” of the loan. This percentage figure includes additional fees added to the loan amount.

Here are the details of what is included in the APR:

• Base Interest Rate: This is the interest rate that the lender charges you for borrowing money.
• document preparation fee: Lenders charge money to prepare an estimate of your loan. These loan fees usually range between $50 and $100.
• Underwriting Fee: Your mortgage lender analyzes your financial situation. This includes your credit score, tax returns, income and bank statements. Some lenders have a fixed fee, while others use a percentage of the mortgage amount.
• Loan Origination Fee: These fees cover the processing of your loan application. A typical origination fee would be 0.5% and 1% of the total loan amount. Some financial institutions include these fees with the underwriting costs.
• closing costs: The APR includes closing costs such as escrow fees, prepaid interest, discount points and other fees when the mortgage is approved.

It’s good to note that credit card APRs typically have a variable rate – they can change from month to month. However, the APR on mortgages are usually fixed APR rates.

Since the APR for a loan includes all associated loan costs, the APR rate is always higher than the interest rate.

how to calculate apr

Calculating APR is the best way to compare loan offers. This is because the interest rates are similar among lenders. However, the mortgage fee included in the APR can significantly affect the total cost of borrowing. Each lender has its own prices; Therefore, it is important to calculate the APR when comparing mortgages. Even a one percent difference in APR can affect the mortgage cost by thousands of dollars.

Calculating the APR for a mortgage is relatively simple. Here is what you do:

• Add up the total interest of the loan and fees
• divide the amount by the loan principal
• divide the result by the number of days in the loan term
• multiples of 365
• To get the APR percentage, multiply the total by 100.

Here is the APR formula:

APR = ((Total Interest + Fees ÷ Loan Amount) ÷ Days in Loan Term) x 365 x 100

Using a mortgage calculator is the easiest way to compare mortgages and find out how much you can borrow.

Remember, when comparing mortgages using APR data, always compare like for like. For example, you’ll need a better comparison by comparing the APR on a 30-year fixed-rate mortgage with a lender offering an adjustable-rate mortgage.

apr vs interest rate

The interest rate on a mortgage isn’t the only cost you pay to the mortgage lender. Financial institutions charge additional fees when issuing mortgages. These charges are added to the total cost of borrowing. Therefore, you may end up paying more for your mortgage if the APR is higher, despite the lower interest rate.

Lenders advertise their best interest rate versus the APR mortgage rate. Thanks to the Truth in Lending Act (TILA), mortgage lenders must be clear about their APR fees. However, lenders may exclude specific fees from APR rates to make them appear more attractive. That’s why it’s important to learn what’s included in the APR.

It’s helpful to note that comparing interest rates versus APR is helpful if you intend to hold onto the mortgage for its full term. For example, if you plan to sell your home after five years, the interest rate may be a better metric for keeping the monthly payment low.

Benefits of Comparing APR vs Interest Rate

Most homebuyers look at the interest rate when looking for a suitable mortgage. However, this can be deceiving as some mortgages have attractively low introductory rates. However, add-ons such as annual mortgage insurance can raise the APR, making this a less attractive deal.

Therefore, comparing APRs can be helpful when comparing multiple loan products. Ultimately, you can decide whether the mortgage deal will save you money or be more expensive over the loan term.

Disadvantages of Comparing APRs

Although it is useful to compare APR versus interest rate, there are a few things that can be improved in the calculation of APR. For example, let’s say you decide to refinance, sell your home, or pay off the loan ahead of schedule. In that case, you can’t find the best deal just by comparing APRs. You want a lower monthly payment by paying discount points. In that case, the interest rate may be a better metric than the APR.

Why is the APR higher than the interest rate?

The APR is always higher than the interest rate alone because it is the total cost of the credit. The interest rate is only a variable at the time of applying for the loan. Other costs that affect the APR percentage figure include discount points, loan origination fees, mortgage insurance and closing costs.

What is a good APR for a mortgage?

The best APRs for mortgage loans depend on market rates and other economic factors. Additionally, factors such as your credit score can affect the annual percentage rate. For example, a good APR for someone with good credit is different from someone with excellent credit and a FICO credit score over 750.

It’s important to note that a good APR for a mortgage depends on the term. For example, beginning in 2023, 6% may be appropriate for a 15-year fixed-rate mortgage. But for a 30-year fixed-term mortgage, a 7% APR may be more realistic. Hence, it is important to check the market trends.

Here are some tips for locking in the best APR for a mortgage:

• Build a good credit history and avoid getting into debt before applying for a mortgage
• Check to see if you’re eligible to apply for specialty loans – FHA, VA, or USDA loans are some popular options.
• Take the time to compare interest rates and APRs from different lenders

conclusion

It’s important to understand the difference between interest rates and APRs when comparing mortgage offers. The APR takes into account all the fees associated with your loan. In contrast, the interest rate is simply the cost of borrowing. Therefore, comparing APRs can help you make a more informed decision about which mortgage offer is best for you. However, depending on your needs and goals, interest rates may be a better metric for comparison.

Note by BigPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.