The annual percentage rate (APR) and interest rate are two critical metrics affecting the cost of borrowing money. Although both figures are related, knowing the difference between interest rates and APR is vital when comparing mortgage offers. For example, learning how APR is calculated could save you thousands of dollars on your home loan.
APR versus interest rate gets confusing because some people use the terms interchangeably. Also, some mortgage lenders prominently display their loan interest rates — usually because the interest rates are lower than the annual percentage rate. So typically, you must hunt for the APR in the small print of loan terms.
What’s the deal with calculating interest rates and APRs? How can you decipher these figures to determine the actual cost of your mortgage? What is a good APR for loans when comparing mortgage rates?
This article helps you know how to compare lender fees to get the best deal on your mortgage.
What is an Interest Rate?
An interest rate is the amount of money a lender charges you to borrow money. It is expressed as a percentage and represents the additional fees you must repay in addition to the principal loan amount. Depending on the loan type, the interest rate could be fixed for a period or a variable rate that changes with market conditions.
When you borrow money as a private loan, mortgage, or on a credit card, you must repay the 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 lower risk and is easier for borrowers to calculate future mortgage payments. The monthly principal and interest rates remain stable.
- Adjustable-rate mortgage (ARM): A mortgage with a variable rate usually has a lower starting interest rate for a specific period. However, adjustable-rate loan interest rates can increase or decrease depending on benchmark rate changes. Usually, it takes more work to predict the future costs of financing monthly repayments. As a result, mortgage repayments will change over time.
Related: A guide to interest rates.
How to calculate the interest rate
To calculate the yearly 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 a lender offers. These factors include market rates, inflation, and economic conditions.
Lenders also assess your financial profile when calculating the interest rate for a home loan. For example, they consider your debt-to-income ratio, credit score, and the amount of down payment. Anything you can do to boost your credit score will help secure lower interest rates.
Apart from the changes with the market rate — which you have no control over — you can affect the interest rate by lowering balances on credit cards and improving your credit history.
However, just using the interest rate doesn’t allow you to calculate the total cost of mortgage payments. 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, comparing the ultimate cost of a mortgage involves knowing the annual percentage rate.
Related: The ultimate guide to home loans.
What is an Annual Percentage Rate (APR)
APR stands for annual percentage rate. The APR represents a more accurate mortgage, personal loan, or credit card borrowing cost. It is what’s called the loan’s “effective interest rate.” This percentage figure includes the additional fees added to the loan amount.
Here is a breakdown of what the APR includes:
- Base interest rate: This is the interest rate the lender charges you to borrow money.
- Document preparation fees: Lenders charge money to prepare your loan estimate. These loan fees usually cost between $50 and $100.
- Underwriting fees: Your mortgage lender analyzes your financial situation. This includes your credit score, tax returns, income, and bank statements. Some lenders have a flat fee, whereas others use a percentage of the mortgage amount.
- Loan origination fees: These fees cover processing 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 underwriting costs.
- Closing costs: The APR includes closing costs like the escrow fee, 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, APRs on mortgages are usually fixed APR rates.
Because APRs for loans include all associated loan costs, the APR rate is always higher than the interest rate.
How to calculate APR
Calculating the APR is the best way to compare loan offers. This is because interest rates between lenders are similar. However, mortgage fees included in the APR can significantly affect the total cost of borrowing. Each lender has their prices; therefore, calculating APR is critical when comparing mortgages. Even a one percent difference in APR can affect mortgage costs by thousands of dollars.
Calculating the APR for a mortgage is relatively straightforward. Here is what you do:
- Add the total interest of the loan and the fees
- Divide the sum by the loan principal
- Divide the result by the number of days in the loan term
- Multiple by 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 know how much you can afford to borrow.
Remember, when comparing mortgages using the APR data, always compare like-for-like. For example, you will need a better comparison by comparing the APR on a 30-year fixed-rate mortgage to a lender offering an adjustable-rate mortgage.
APR vs. Interest Rate
The interest rate on a mortgage is not the only cost you pay to the mortgage lender. Financial institutions charge additional fees when issuing mortgages. These fees are added to the total cost of borrowing. Therefore, you could pay more for your mortgage if the APR is higher, despite the lower interest rate.
Lenders advertise their best interest rate vs. APR mortgage rate. Thanks to the Truth in Lending Act (TILA), mortgage lenders must be upfront about their APR fees. However, lenders may exclude specific fees from the APR rates to make them appear more attractive. So learning what is included in the APR is important.
It’s good to note that comparing interest rates vs. APR is helpful if you intend to keep the mortgage for its entire term. For example, if you plan to sell your home after five years, the interest rate may be a better metric to keep monthly payments lower.
The 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 because some mortgages have enticingly low introductory rates. However, add-ons like annual mortgage insurance can increase the APR, making it a less attractive deal.
Therefore, comparing APR can help compare multiple loan products. Ultimately, you can decide if the mortgage deal will save your money or be more expensive over the loan term.
The disadvantages of comparing APR
Although comparing APR vs. interest rate is useful, some things could be improved in calculating APR. For example, suppose you decide to refinance, sell your home, or pay off the loan before its term. In that case, you may not find the best deal by only comparing APR. You may want lower monthly payments by paying discount points. In that case, the interest rate may be a better metric than APR.
Why is APR Higher Than the Interest Rate?
The APR is always higher than the interest rate alone because it is the total cost of credit. The interest rate is just one variable when applying for a loan. Other costs impacting the APR percentage figure include discount points, loan origination fees, mortgage insurance, and closing costs.
What is a Good APR for a Mortgage?
Good APRs for mortgage loans depend on the market rate and other economic factors. Additionally, factors like your credit score can affect the annual percentage rate. For example, a good APR for someone with good credit differs from someone with excellent credit and a FICO credit score of over 750.
It’s important to note that a good APR for a mortgage depends on the term. For example, at the start of 2023, 6% may be suitable for a 15-year fixed-rate mortgage. But 7% APR may be more realistic for a 30-year fixed-term mortgage. Therefore, it’s vital to check out market trends.
Here are some tips on locking in the best APR for a mortgage:
- Build a good credit history and avoid taking out a loan before you apply for a mortgage
- Check to see if you are eligible to apply for particular loans — FHA, VA, or USDA loans are some popular options
- Take time to compare interest rates and APRs from various lenders
Understanding the difference between interest rates and APR when comparing mortgage offers is crucial. APR takes into account all fees associated with your loan. In contrast, the interest rate is only the cost of borrowing. Therefore, comparing APR 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.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.