Interest Rate vs APR: Know the Difference

Interest rate vs APR refers to the difference between two mortgage terms that sound alike but are in fact quite different. When shopping for a mortgage, knowing what the terms "interest rate" (also called mortgage rate, stated rate or advertised rate) and "APR" (annual percentage rate) helps you find your best mortgage deal.

The interest rate of a mortgage is simply the number used to calculate its monthly payment. If you borrow $200,000 with a fixed-rate mortgage, and the interest rate is 4.50 percent, the principal and interest payment is 1,013.37. That's true if you pay nothing to get your home loan, or if you pay $10,000 to get your home loan.

How APR Helps You Shop for a Mortgage

It's obvious that a 4.5 percent mortgage that costs $10,000 is not as good as a 4.5 percent loan costing nothing. But what if you can choose between 4.5 percent and no fees, or 4.125 percent with a $969.30 payment at a cost of $10,000? Which is better?

That's where APR comes in. The APR incorporates both the interest rate and the costs of the mortgage -- including discount points, origination fees, interest and other fees. In this case, the APR for the no-cost mortgage is the same as its advertised rate, or 4.5 percent. The APR for the loan with the lower rate and payment is 4.56 percent. In this case, the loan with the higher rate is the better deal.

Truth-in-Lending

Mortgage lenders are required to provide customers with a Truth-in-Lending (TIL) disclosure within three days of application, but many will supply one to consumers without requiring them to apply. Interest rates, lender fees and other charges are subject to change until the loan is locked, but a TIL helps you understand how much a mortgage costs and makes it easier to compare loan offers.

You should be issued a new TIL when your loan is locked, and any time after that if there is a "material change" in the program -- for example, if you're refinancing and the appraisal comes in lower than expected, resulting in an 85 percent loan instead of an 80 percent loan.

APR Essentials

The lowest APR is not automatically the best deal. APR has a few shortcomings:

  • APR is only meaningful when comparing the same kind of loan. You can compare two 5/1 ARMs against each other, but not a 5/1 ARM and a 30-year fixed mortgage.
  • APR does not account for loans that are not held for their full terms -- if you pay upfront to get a lower interest rate for 30 years, but only keep the loan for five years, the APR increases substantially. In the above example, the payment for the no-cost loan is $1,013.37. The loan costing $10,000 has a payment of $969.30, which is $44.07 less. If you keep the loan only five years, you'll have paid $10,000 upfront to save a total of $2,644. For this reason, if you don't know how long you'll keep the loan, or know you won't have if for many years, it makes sense to choose a mortgage with lower up-front costs.
  • The APR for an adjustable rate mortgage (ARM) is inaccurate because it's based on what the rate would be today if it adjusted according to the loan terms. However, it's unlikely that rates in the future when your loan resets will be the same as they are today -- it's just a guess.
  • Not all lenders include the same charges in their APR calculation, so minor differences between lenders may be meaningless.

Want actual examples of interest rate vs APR? Go to LoanExplorer by LendingTree. Indicate your credit score, loan amount and your purchase price or home value. You can sort the results by interest rate or by APR, and by clicking "details," you get a list of the lender's charges. Keep in mind that third party fees (title and escrow, appraisal fees, etc.) might not be disclosed because the lender does not set those prices.

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