You might encounter the terms APR and interest rate when you shop for a home loan. It’s easy to confuse the two and use them interchangeably because your interest rate and your APR serve a similar function. However, there are a few differences that you need to know.
Here’s how to calculate APR and interest rate as well as how to compare lenders so you understand the differences before you get a mortgage.
What Is Interest Rate?
Your interest rate is the percentage you pay to borrow money from a lender for a specific period of time. Your mortgage interest rate might be fixed, which means it stays the same throughout the duration of your loan. Your mortgage interest rate might also be variable, which means it might change depending on market rates.
You’ll always see your interest rate expressed as a percentage. You’re responsible for paying back both the initial amount you borrow (your principal) plus any interest that accumulates on your loan.
Let’s look at an example. Say you borrow $100,000 to buy a home and your interest rate is 4%. This means that at the start of your loan, your mortgage builds 4% in interest every year. That’s $4,000 annually, or about $333.33 a month.
Your principal balance is high during the beginning of your loan and you’ll pay more money toward interest as a result. However, as you chip away at your principal through monthly payments, you owe less in interest and pay a higher percentage of your payment to your principal. This process is called mortgage amortization.
What Is APR?
APR stands for “annual percentage rate.” Your APR includes your interest rate plus additional fees and expenses associated with taking out your loan. APR is a broader look at what you’ll pay when you borrow money and you can consider it your effective rate of interest. The APR includes your interest rate as well as any prepaid interest, private mortgage insurance (PMI) or other fees you need to pay. Your APR will reflect a higher number than your interest rate.
Interest Rate Vs. APR: What’s The Difference?
Thanks to the Truth in Lending Act (TILA), your lender must tell you both your interest rate and your APR. You’ll see this information on both your Loan Estimate (which you’ll receive 3 days after you fill out your mortgage application) and your Closing Disclosure (which you receive 3 days before you close on your home).
Remember to consider both the interest rate and the APR when you decide on the best mortgage loan for you.
How Are Interest Rates Calculated?
Your lender calculates your interest rate using your individual data. Every lender uses their own individual formula to determine how much you’ll pay in interest. It’s possible to get 10 different interest rates from 10 different mortgage providers. Lenders also take into account things like current market interest rates and real estate economy conditions when they calculate your rate.
There are a few ways that you can get a lower interest rate from your mortgage lender. Anything that you do to lower the risk for your lender will in turn lower your rate. The first thing that you can do is raise your credit score. Your credit score is a three-digit number that tells lenders at a glance how you use credit. If you have a high credit score, you usually make payments on time and you don’t borrow more money than you can afford to pay back.
Lenders see you as riskier if you have a low credit score. You may have a history of missed payments, so a lender may compensate for the risk that your score presents by offering you a higher interest rate.
Here are some ways to raise your credit score:
- Always make your minimum loan and credit card payments on time.
- Limit the amount of money that you put on credit cards.
- Pay down as much of your debt as you can.
- Avoid applying for new loans when you’re preparing to get a mortgage.
You can also lower your interest rate by choosing a government-backed loan. Government-backed loans (such as VA loans, FHA loans and USDA loans) are insured by the federal government. This means that if your home goes into foreclosure, the government body that backs your loan will pay your lender back. Consider choosing a government-backed loan for an often lower interest rate compared to conventional loans, which are not backed by the government. However, mortgage insurance will factor into your payment, so it’s important to weigh all of your options.
How Is APR Calculated?
Unfortunately, you have less control over your APR compared to your interest rate. Your lender controls the other factors that go into your APR like discount points and broker fees.
Though there are some things you can do to lower your APR, such as avoiding private mortgage insurance by offering at least 20% down, the best way to get a better rate is to compare lenders. When using APR to compare rates, be sure to compare apples to apples as far as loan programs. Basically, don’t compare the APR on a 30-year fixed mortgage with one lender and a 5/1 adjustable rate mortgage (ARM) with another, as it’s not an equal comparison.
You’ll see two interest rates when you shop for a home: your interest rate and your APR. While your interest rate is the percentage of interest you pay on your loan, your APR includes your interest rate as well as any additional fees or expenses you’ll pay to your lender. Some of the most common additional fees include brokerage fees, private mortgage insurance and discount points. You can think of your APR as the effective interest rate you’ll actually pay once you have your loan.
Lenders must tell you both your interest rate and your APR before you close on a loan. You can lower your interest rate by controlling your credit score and choosing a government-backed loan. However, you have less control over your APR because many of these costs are set by the lender. That said, the best way to find a lower APR is to compare similar loan programs with different lenders.
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