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What’s the difference between interest rate and APR?

What’s the difference between interest rate and APR?

Christine Demos
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When trying to get a mortgage, you’ll receive two important percentages in the Loan Estimate — interest rate and annual percentage rate (APR). Both can be very useful to help determine which loan is right for you. But what are they? How do they differ? And how can you use them to compare? Let’s break it all down.

WHAT IS INTEREST RATE?

Every month you pay your mortgage payment, you’re typically paying a portion of the principal (the borrowed amount) plus interest.

Your interest rate, expressed as a percentage, is the amount charged by the lender to borrow the principal.

Interest rate (also known as the note rate) will tell you how much interest you’ll pay each year, and helps you calculate your monthly mortgage payment. Interest rate is determined from various factors, such as market conditions, credit score, down payment, loan type and term, loan amount, the home’s location, and the type of interest rate (fixed or adjustable).

Don’t assume a certain lender will offer a better loan just because the interest rate is lower. There may be additional fees associated with the loan, which is where annual percentage rate (APR) can come in handy.

WHAT IS ANNUAL PERCENTAGE RATE (APR)?

Annual percentage rate (APR) reflects the interest rate, but it also takes into account additional fees.

APR is a broader measure that outlines the true cost of taking out a loan.

It can help you understand the compromise between interest rate and additional fees. Due to other fees included, your APR is higher than your interest rate, and it’s also expressed as a percentage.

Once you’ve applied for your mortgage and have a ratified contract with a property address, your lender is required to provide a Loan Estimate within three business days. Lenders are required by law to disclose both the interest rate and the APR.

What’s included in an APR?

  • Interest rate
  • Closing costs (even if closing costs are seller-paid)
  • Origination fees
  • Mortgage insurance
  • Discount Points
  • Broker fees (if using a broker)
  • Any lender fees

You can use the comparisons section of your Loan Estimate to get an idea of how your loan’s APR stacks up against loans from other lenders.

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WHY DO WE NEED BOTH?

The primary difference between the two is that your interest rate helps estimate what your monthly payment will be. On the other hand, APR calculates the total cost of the loan. Therefore, using both can help you make a truer loan comparison.

APR is especially useful if you plan on keeping your loan for most of the loan’s term, 15 years or 30 years for example. Since APR includes the total cost over the life of the loan, you may focus on this percentage as it’s the truest indicator of complete, long-term costs.

If you’re interested in determining your monthly payment, interest rate is probably what you want to focus on. Just don’t forget to include any taxes, insurance, and mortgage insurance when calculating your monthly payment.

WHAT ARE THE LIMITATIONS OF APR?

APR does have some limitations. For one, it assumes you’ll never make extra payments toward your principle amount.

It also assumes you’ll keep your loan for its entire term, which doesn’t happen very often; most people will move or refinance at some point.

If you’re getting an adjustable-rate mortgage, you should also note that APR doesn’t reflect the maximum interest rate of the loan, so be careful when using APR as a comparison tool.

WHAT ELSE SHOULD YOU CONSIDER?

While APR is a truer cost of the loan, keep in mind that all of those costs may not truly be paid by you. Let’s suggest you’re taking out a VA loan, and you negotiated to have up to $10,000 of your settlement costs covered by the seller. Your APR may be quite high, but realistically, the seller could be paying for a chunk of those costs, such as your closing costs, origination fee, and discount points. So don’t get scared off by an APR until you truly understand what you’re paying.

Interest rate and APR can be complicated, so be sure to ask your mortgage banker if you have any questions.