You might encounter the terms “APR” and “interest rate” when shopping for a home loan. It’s easy to confuse the two and use them interchangeably, because your interest rate and your APR serve similar functions. However, interest rate and APR have a few differences that you should be aware of.
Let’s learn how to calculate APR versus interest rate, as well as how to compare lenders so you understand the differences before you get a mortgage.
What Is APR?
APR stands for “annual percentage rate.” Your APR includes your interest rate as well as additional fees and expenses associated with taking out your loan, such as any prepaid interest, private mortgage insurance (PMI), some closing costs, mortgage points (also called discount points) and other fees you may need to pay.
What Is Interest Rate?
Your interest rate is the percentage you pay to borrow money from a lender for a specific period of time. Your mortgage interest rate might be fixed, meaning it stays the same throughout the duration of your loan. Your mortgage interest rate might also be variable, meaning it might change depending on market rates.
You’ll always see your interest rate expressed as a percentage. You’re responsible for paying back the initial amount you borrow (your principal) plus any interest that accumulates on your loan.
Let’s consider an example. Say you borrow $100,000 to buy a home, and your interest rate is 4%. This means that at the start of your loan, your mortgage builds 4% in interest every year. That’s $4,000 annually, or about $333.33 a month.
Your principal balance is high at the beginning of your loan term, and you’ll pay more money toward interest as a result. However, as you chip away at your principal through monthly payments, you owe less in interest and a higher percentage of your payment goes toward your principal. This process is called mortgage amortization.
What Is The Difference Between Interest Rate And APR?
The main difference between interest rate and APR is that interest rate represents the cost you’ll pay each year to borrow money, while APR is a more extensive measure of the cost to borrow money that takes additional fees into account. Since APR includes your interest rate and other fees connected with your loan, your APR will reflect a higher number than your interest rate. You can also consider APR to be your effective rate of interest.
Thanks to the Truth in Lending Act (TILA), your lender must tell you both your interest rate and your APR. You’ll see this information on your Loan Estimate (which you’ll receive around 3 days after filling out your mortgage application) and your Closing Disclosure (which you’ll receive no later than 3 days before closing on your home). Remember to consider both the interest rate and the APR when deciding on the best mortgage loan for you.
How Are Interest Rates Calculated?
You may be wondering, “how are mortgage rates determines?” Your lender calculates your interest rate using your personal data. Every lender uses their own formula to determine how much you’ll pay in interest. It’s possible to get 10 different interest rates from 10 different mortgage providers. Lenders also take into account factors like current market interest rates and real estate economy conditions when calculating your rate.
You can get a lower interest rate from your mortgage lender a few different ways. Anything you do to lower the risk for your lender will usually, in turn, lower your rate. The first action you can take is to raise your credit score, which is a three-digit number that tells lenders at a glance how you use credit. If you have a high credit score, you usually make payments on time, and you don’t borrow more money than you can afford to pay back.
Lenders see you as riskier if you have a low credit score. You may have a history of missed payments, so a lender may compensate for the risk that your score presents by offering you a higher interest rate.
Here are some ways to raise your credit score:
Always make your minimum loan and credit card payments on time.
Limit the amount of money that you put on credit cards.
Pay down as much of your debt as possible.
Avoid applying for new loans when you’re preparing to get a mortgage.
You can also lower your interest rate by choosing a government-backed loan, such as a VA loan, FHA loan, or USDA loan. If your home goes into foreclosure and you have a loan that’s insured by the federal government, the government agency backing your loan will reimburse your lender.
Consider choosing a government-backed loan, which may have a lower interest rate than a conventional loan, which isn’t government-insured. However, mortgage insurance will factor into your payment, so it’s important to weigh all of your options.
How Is APR Calculated?
Unfortunately, you have less control over your APR than your interest rate. Your lender controls the other factors that go into your APR, like origination costs and broker fees.
Though there are some ways to lower your APR, such as avoiding private mortgage insurance by offering at least 20% down, the best way to secure a better rate is to compare lenders.
When using APR to look at rates, be sure to compare apples to apples as far as loan programs. In other words, don’t compare the APR on a 30-year fixed-rate mortgage with one lender and a 5/1 adjustable rate mortgage (ARM) with another, since these don’t represent an equal comparison.
Conclusion
While your interest rate is the percentage of interest you pay on a loan, your APR includes your interest rate along with any other fees or expenses you’ll pay your lender. Some of the most common additional fees are brokerage fees, private mortgage insurance and discount points. You can think of your APR as the effective interest rate you’ll actually pay once you have your loan.
Lenders must tell you both your interest rate and APR before you close on a loan. You can lower your interest rate by controlling your credit score and, possibly, by choosing a government-backed loan. However, you have less control over your APR because the lender sets many of these costs. That said, the best way to find a lower APR is to compare similar loan programs from different lenders. Understanding your APR and interest rate is crucial when taking out a mortgage to purchase or refinance a home.