Mortgage APR vs Interest Rate: What’s the Difference?
A mortgage’s annual percentage rate (APR) and its interest rate aren’t the same thing, and not understanding the difference can cost you thousands of dollars, depending on the term of your home loan and how long you stay in the house.
Let’s take a look at the difference between your APR and your interest rate, and how they affect how much home you can afford.
How are they different?
|Mortgage APR vs Interest Rate|
The cost of credit, based on the the interest, fees and loan term, expressed as a yearly rate. APR was created to make it easier for consumers to compare loans with different rates and costs. By law, the APR must be disclosed in all advertising. (Source: Truth in Lending Act)
The amount charged by a lender to borrow money. The interest rate is expressed as a percentage of the principal loan amount.
What is included in APR?
As a broader measure of the cost of borrowing, this includes prepaid finance charges such as mortgage insurance, mortgage broker fees, most closing costs, discount points and loan origination fees. (Source: Truth in Lending Act )
What is included in an interest rate?
Only the cost of borrowing money from a lender is included.
If you applied for a mortgage and received a Loan Estimate from one or more lenders, you can find the interest rate on the first page under “Loan Terms,” and the APR on the third page under “Comparisons.”
Same interest rate, different APRs
What if mortgage lenders only advertised their interest rates? When shopping for a mortgage, the interest rate is a useful figure. It’s what the lender uses to calculate your monthly payment for a given loan amount and repayment period. But along with advertised mortgage interest rates, mortgage lenders are required under the federal Truth in Lending Act (TILA) to provide an APR whenever an interest rate is offered. This is because, by itself, the interest rate provides no information about the actual cost of the loan.
Consider the following two 30-year fixed mortgages:
|Loan A||Loan B|
Glancing at the interest rate, it appears that Loan B is the better deal. However, is Loan A the better deal because the upfront costs (including the cost of buying discount points at closing to reduce your interest rate and monthly payment) are lower?
To answer that question, we first have to calculate the APR. To do that, first we’ll add in the points and fees to the loan amount to arrive at the adjusted balance. One point is equal to 1 percent of your mortgage amount (or $1,000 for every $100,000). For this example, we’ll assume that the borrower does not have to pay mortgage insurance. Otherwise, mortgage insurance would also be included in the APR calculation.
|Loan A||Loan B|
|Adjusted balance||$100,000 + $1,000 + $1,200 = $102,200||$100,000 + $3,000 + $600 = $103,600|
Next, we’ll calculate the monthly payment on the adjusted balance using the loan’s interest rate and adjusted balance. You can do this using a loan-payment calculator tool. Using the mortgage calculator, the monthly payment (principal and interest) for the loans is as follows:
|Loan A||Loan B|
Finally, to calculate the APR, we’ll return to the original loan amount and look for an interest rate that will result in the monthly payment calculated above.
This can be done by guessing the correct APR and plugging into the calculator until you come up with the right payment amount. For Loan A, using the mortgage calculator we adjusted the home price to $100,000 and tried an interest rate of 3.70 percent in the calculator, but the payment came out to $460 – just a little too high. But when we plug an interest rate of 3.68 percent into the calculator, the payment comes out to $459 – the same payment calculated above. So for Loan A, the APR is 3.68 percent. We’ll use the same method to come up with the APR for Loan B.
|Loan A||Loan B|
From this example, we can see although Loan B has higher upfront costs, it’s still a better deal than Loan A in the long run.
The mortgage with the lowest APR isn’t always the best deal
In the calculation above, we showed that Loan B is the better deal. But that calculation assumes the borrower will keep the loan for its entire 30-year term.
RJ Winberg, a Realtor based out of Orange County, Calif., says time frame matters when comparing APRs because the cost of the points is being spread out over a shorter time period.
Let’s look at what would happen if the borrower planned on selling the home in five years.
|Loan A||Loan B|
|Points and fees||$2,200||$3,600|
|All costs, five years||$29,740||$30,660|
|All costs, 30 years||$167,440||$165,960|
When you look at the cost of borrowing money over five years rather than 30, Loan A is actually a better deal. Over five years, you would save $920 by choosing the Loan A with its lower upfront costs, even though the monthly payment is higher.
Winberg says if a borrower plans to keep his or her mortgage for a long time, shopping for the lowest APR makes the most sense. But for people who may move or refinance sooner, choosing a loan with a smaller amount of fees may be the more affordable choice, though the interest rate may be higher, he says.
Your best bet: Do the math according to your future plans, to see if the upfront fees would outweigh the interest you’d pay as long as you plan to stay in the home.
Watch out for APRs on adjustable rate mortgages
So far, we’ve only discussed APRs for 30-year fixed-rate mortgages. But in the real world, a buyer may be comparing several loan offers: 30-year fixed, 15-year fixed or an adjustable-rate mortgage (ARM). Keep in mind that APRs can only be used to compare the same kind of loan: 30-year fixed to 30-year fixed, 5/1 ARM to 5/1 ARM, and so on.
If you are considering an ARM, remember that no one can predict how interest rates will change over time. The APR for an ARM is calculated based on the assumption that the loan will be fixed for its introductory periods and then adjusted according to today’s economic index values (“today” being the date that the disclosures are issued). So the APR for a 5/1 LIBOR ARM, which is fixed for five years and then begins adjusting based on the LIBOR index, would be calculated on the assumption that it will remain at its start rate for five years, adjust according to today’s LIBOR, and stay that way for the remaining 25 years.
Of course, it is highly doubtful that in five years, when the interest rate adjusts, the LIBOR will be at the exact same level it is today. It’s also practically impossible that the LIBOR rate will then remain the same for the following 25 years. As such, calculating the APR on an ARM is so unreliable that only by way of an extreme stretch of the imagination can it be considered a “real” rate.
Because ARMS are calculated based on current economic conditions, the APR of a loan on Monday will be different from the APR of that same loan on Friday. (Fixed-rate mortgage rates can also fluctuate until you lock in a rate with your lender.) If you really want to compare the APR of ARM loans, get your mortgage quotes on the same day, and preferably at the same time. This is easiest to manage with the help of an online marketplace like LendingTree, which offers real-time rates and custom quotes.
When shopping for your mortgage, it’s important to remember …
- The interest rate. Ask each lender you work with for a list of its current mortgage interest rates. Find out whether the rate is fixed or adjustable. Keep in mind that interest rates for ARMs may be lower now, but when interest rates go up, so will your monthly payment.
- Total costs of fees and points. A mortgage involves many fees, including loan origination or underwriting fees, broker fees and other closing costs. Ask your lender for an estimate of its specific fees and other costs. Many of these may be negotiable.
- The time you plan to stay in the home. If you plan to stay in your home for 30 years or more, it may make sense to go with the loan with the lowest APR, because it could cost you less. But if you plan to sell within a few years, it may make sense to accept a higher APR and pay fewer fees at the outset, because, as our example above suggests, the total costs will be less over the first few years.
Shopping around for a home mortgage will help you get the best deal. It’s not always easy to compare different mortgages, apples to apples, but the Federal Trade Commission (FTC) has a mortgage shopping worksheet that can help.
Frequently asked questions
What are points?
Mortgage points are fees paid directly to the lender in exchange for a reduced interest rate. This may also be referred to as “buying down the rate.” Paying points lowers your monthly mortgage payment. One point is equal to 1 percent of your mortgage amount (or $1,000 for every $100,000).
What are origination fees?
The origination fee is money that a lender or bank charges a client to complete a loan transaction. It may encompass a variety of different fees added together, such as an underwriting and processing fees and other administrative costs. Origination fees will be listed on Page 2 of your Loan Estimate.
What’s mortgage insurance?
Borrowers who make a down payment of less than 20 percent of the purchase price of the home may be required to pay for mortgage insurance. Mortgage insurance protects the lender in the event that you default on your mortgage payments. It lowers the lender’s risk in making the loan.