What is APR?

The difference between the interest rate you pay on a loan and the annual percentage rate, or APR, is essential to understand when you're shopping for a loan or a mortgage.

The interest rate tells you how much you pay the lender in addition to the amount you borrow. What is APR? It tells you the total annual cost of the loan, including the interest rate and fees you pay the lender.

We'll walk you through how APR works in real estate, what an APR includes, and the different types of APRs.

How does APR work?

Here's a simple APR definition: APR helps you understand how much a specific loan costs. APR is calculated by adding the mortgage interest and fees over the life of the loan and dividing by the loan term to get your annual cost.

With mortgages, loan fees typically are all paid up-front. Closing costs usually total 3% – 6% of your loan amount, but you may also have paid an application fee up front. APR takes all such fees and adds them to the interest you pay to arrive at the total annual cost of your loan.

Interest rates and APRs are listed on a mortgage offer as percentages. You'll commonly see a specific loan type listed with both the interest rate and the APR. For example, a lender like Rocket Mortgage may offer a 30-year fixed loan with an interest rate of 6.375% and an APR of 6.638%. The difference between the interest rate and the APR represents the fees you'll pay.

Mortgage lenders are required to disclose the APR in addition to the interest rate in all advertising and loan offers. That way, you won't be caught off guard by the costs.

Your lender will calculate and disclose your APR on your Loan Estimate, which you receive within 3 days of submitting your loan application and documentation. It will be confirmed on your Closing Disclosure, which you'll receive at least 3 days before your scheduled closing.

APR vs. interest rate

The interest rate tells you how much you'll pay the lender in addition to the loan principal.

The higher your interest rate, the more interest you'll pay. This will be reflected in your monthly mortgage payment. A slight variation in the interest rate can add up to a significant amount over the life of a mortgage, which usually is 30 or 15 years.

The APR usually is higher than the interest rate because it includes costs such as origination fees, mortgage points, closing costs, and mortgage insurance. That makes APR a more comprehensive measure of what a mortgage costs.

Comparing APRs can help you better determine which loan can save you the most money. A loan with a higher interest rate and lower fees can be less expensive overall than one with a lower interest rate and higher costs. APR makes it easier to compare loans directly.

Types of APR

As mentioned, APR is a more comprehensive way to understand the cost of your loan because it includes interest and loan fees.

How APR works with fixed-rate loans

A fixed-rate mortgage has a mortgage rate that remains the same throughout the loan term. Once you close on your loan, your monthly payment for interest and principal will be the same from the first payment to the last.

APR is a one-time disclosure of the annual cost of your loan, including interest and loan fees. Since you usually pay mortgage costs up front, your APR shouldn't change after you close your loan unless you're paying ongoing loan fees that may change over time.

How APR works with adjustable-rate mortgages

An adjustable-rate mortgage (ARM) has an interest rate that changes at specified intervals based on market conditions.

Typically, an ARM has a fixed rate for a specific amount of time. This fixed rate is usually lower than a fixed-rate loan. Once this introductory fixed rate expires, the interest rate adjusts at specified intervals based on market conditions.

For example, if you have a 5/1 ARM, your initial rate is fixed for 5 years, then adjusts once a year thereafter.

There usually are interest rate caps on how much your rate can increase in any single adjustment and a maximum rate for the life of your loan.

APR on an ARM is based on the initial rate for the introductory term. It usually then assumes the current market rate for the rest of the loan. That means the APR on an ARM is an estimate, since you can't know in advance how often the rate will adjust, or by how much.

What does APR include?

As mentioned, the APR includes your interest rate plus fees related to applying for and funding a loan.

Here's what an APR for a mortgage can include:

• Mortgage interest rate. This is the base cost of borrowing money and is in addition to the initial loan amount, or principal.
• Mortgage underwriting fees. These are the fees for reviewing your finances to determine your loan eligibility and your ability to repay the borrowed funds.
• Origination fees. This is the fee lenders charge to process your home loan. Origination fees are typically between 0.5% to 1% of the loan amount.
• Lender or broker fees. These are costs paid to your lender or real estate broker to secure the loan.
• Mortgage points. Any prepaid interest will be included in the APR calculation.

It's a good idea to get a Loan Estimate and shop around for mortgages. When you do, pay close attention to the APR.

How to compare APR quotes

When shopping around for a mortgage, APR quotes can help you gauge the total cost of borrowing.

You can request APR information directly from the lender or ask them what documents or information are required to obtain it.

APRs can also be found on your Loan Estimate and Closing Disclosure. When you get mortgage preapproval, you'll receive what's known as a floating rate. This means it's not locked in and will not be finalized until your loan closes, unless you choose a rate lock.

When looking at APR quotes, pore carefully over the itemized list of fees to make sure the calculations include the same fees. That way, you know you're comparing apples to apples, and the lenders are providing comparable fees.

Why is APR important?

The APR is key to understanding the total costs of your mortgage and looking at the actual costs of a home loan. While the interest rate is the base rate for the loan's cost, the APR includes additional fees.

When comparing mortgage offers, it's important not to mix up the interest rate and the APR. This can help you figure out which is the least-expensive option.

For example, let's say one lender offers you an interest rate of 5% and an APR of 7.45%. Another lender extends you an interest rate of 6%. But here's the thing: the APR is 7.37%. In that case, the second lender will cost you less upfront.

FAQ

Here are answers to common questions about APR.

What is considered a good APR for a mortgage?

A good APR depends on several factors, such as the national average rate and your individual creditworthiness. It's important to compare APRs when shopping for a mortgage.

Does my credit score affect my APR?

A higher credit score can get you a lower interest rate and APR. On the flip side, lower credit scores can mean a higher APR. Taking steps to improve your credit can save you a significant amount on your mortgage over time.

What’s the difference between APR and APY?

The difference between APR and annual percentage yield (APY) is that APR is the total yearly cost of borrowing money, while APY is the total amount of money you can earn in a savings account. An APY factors in compound interest.

The bottom line: Look for home loans with a low APR

When you're shopping around for a mortgage, the lower the APR, the more you'll save during the life of the loan. You'll want to use the APR, not the interest rate, when comparing total loan costs. That simple step will help you determine how much you'll spend on a home loan.

If you're ready to shop for a home, explore your borrowing options today with Rocket Mortgage.

Rocket Mortgage is a trademark of Rocket Mortgage, LLC or its affiliates.