When shopping for a home loan or other types of loans, you are bound to encounter two major terms ─ APR and Interest Rate. While these two terms serve similar functions and are regularly used by lenders, APR and Interest are not the same.
If you are like millions of homebuyers taking a home loan for the first time, knowing how APR and interest rate differ from each other and how to calculate them can greatly improve your lending journey.
In this article, you will learn:
- The difference between APR and interest rate
- How lenders determine your APR and interest rate
- How to calculate APR and interest rates
What is an Interest Rate?
Your interest rate is the cost to borrow money from a lender. Just like when the bank pays you interest to save money in a savings account, you have to pay interest for the loan duration when you take out a loan to buy a home.
Interest rates are always displayed as a percentage of the principal loan amount, and unlike APRs, your interest rate does not include additional fees or lender’s fees. You, as the borrower, are responsible for paying the principal (the initial amount you borrowed) plus the interest as a percentage of the outstanding loan balance that accumulates on your loan.
Let’s look at a quick example. Say you borrowed $200,000 to purchase a house at an interest rate of 4%. This means that at the beginning of the loan, your mortgage increases by 4%. That’s $8000 annually or $666.7 per month.
How Do Lenders Determine Your Interest Rate?
If this is your first time apply for a mortgage, you may be wondering how lenders arrive at specific interest rates. While lenders set their interest rates and fees within the Federal lending guidelines, the rate you obtain could differ from the advertised rates, as every borrower has a different financial situation.
Generally, the advertised interest rates, whether online or offline, are for individuals with the highest credit and financial requirements. And if that’s not you, the interest rate you may get will be based on the following factors:
- Credit score
- Debt-to-income ratio
- Loan amount
- Down payment amount
- Loan program
- Length of the loan
- Discount points
The type of credit or loan you apply for also plays a role in determining your interest rate.
Understanding Fixed- And Adjustable-Rate Mortgages
There are two main types of interest rates ─ fixed and adjustable.
A fixed-rate mortgage has the same interest rate throughout the life of the loan. No matter the changes in the market, the interest rate will never change throughout the mortgage. This type of loan is easy to plan for and is good for borrowers who prefer a fixed amount each month. The most common fixed-rate mortgages are 15-year, 20-year, and 30-year fixed. Depending on your financial situation and qualifications, you could also choose to take out a 10-year fixed-rate mortgage.
Adjustable rates, like the name implies, change throughout the loan. Adjustable-rate mortgages (ARMs) have a set rate for a specific period, and after that, the rate fluctuates based on an index rate. While ARMs offer you the opportunity to lower your monthly payments, the rate can increase depending on the market condition, and so you might not end up saving much if the interest rates are on the rise. Some of the most common adjustable-rate mortgages include 3/1 ARM, 5/1 ARM, and 7/1 ARM.
What is APR?
APR stands for “Annual Percentage Rate.” It is also listed as a percentage, but the APR is typically higher than the interest rate. This is because APR includes a borrower’s interest rate, additional fees, and closing costs associated with obtaining a loan. It is a broader perspective of all the expenses you will have to pay for when taking out a loan.
Typically, it is common for your APR to include the following items:
- Interest rate
- Origination fee
- Closing costs
- Lender’s fee
- Private Mortgage Insurance (for down payment less than 20%)
- Discount points
- Application fee
- Underwriting fee
Some fees, such as the following, are not to be included in APR:
- Title or abstract fee
- Notary fee
- The closing agent or title attorney
- Home inspection
- Recording fee
- Escrow Agent fees
- Transfer taxes
- Credit report review
- Flood Hazard determination fees
Remember, the fees associated with your loan depend on the type of loan and lender. APRs are usually paid annually over the life of the loan. Before taking out a loan, you should also inquire if it is a fixed-APR or variable APR. So, it is essential that you carefully evaluate each of them to find the option that suits your long-term financial goals.
How APR Is Determined
Unlike interest rates, APRs are not regulated by government guidelines and regulations. That is, lenders decide on the amount they want to charge for any fees borrowers have to incur. For example, some lenders may charge more on origination fees than others. As a result, two lenders in the same local area with similar interest rates might offer entirely different APRs.
One small note if you are worried about being charged hidden fees: the Truth in Lending Act (TILA) requires lenders to provide borrowers with written disclosures about important items of a loan before they are legally bound to pay, including the APR in all mortgage documents. This gives you an idea of how much additional fees you will incur by taking out a mortgage, in addition to the interest. However, lenders don’t always include all the fees. If you are unclear about what you are paying for, ask your lender to explain how they arrived at your APR.
You can also check out the “Comparisons” section on page 3 of your loan estimate, which outlines how much you will have paid in principal, interest, mortgage insurance, and loan costs. Measures listed under the Comparisons section is particularly helpful if you’re comparing different lenders.
Differences Between APR and Interest Rate
Interest rates and APR both give you an insight into how much you’ll have to pay for a loan. However, several differences and similarities set them apart. The table below shows how APR and interest rate differ and what they have in common.
How Loan Lengths Impacts APRs and Interest Rates
The length of your loan also influences how much you will have to pay throughout the loan. If all loan conditions are met, it is common for 15-year loans to have lower APR and interest rates when compared to 30-year loans. This is because you are paying off the loan within a shorter period.
Thanks to technology, you can now calculate your loan APRs and Interest rate using online calculators. Online calculators like NerdWallet Calculator are great tools for finding your loan APR. You can also calculate your mortgage interest-only payments using the RealtyHop Mortgage Payment Calculator.
These days, it is common for lenders to advertise deceptively low-interest rates on mortgages to attract unsuspecting loan consumers. The interest rates are usually tempting because they rarely reveal the actual cost of the loan. When shopping for a mortgage, pay more attention to the interest rate because it plays a massive role in determining your monthly mortgage payments.
More importantly, if the APR is a lot higher than the interest rate, it is a sign that too many additional fees are being charged. Ask your lender to break down the listed additional fees included in the loan.
Elijah O. Agor, CFP
Elijah O. Agor is a real estate, 1031 exchange, and mortgage writer. He is a certified financial planner, former loan originator, and chief realtor for Dsquared Realty. In the past, Elijah advised first-time and seasoned home buyers on real estate and mortgage decisions in the Greater Atlanta area. Since hanging up (burning) his suits and ties, Elijah now works to make mortgage and real estate topics understandable and jargon-free.