APR vs. interest rate: What's the difference?

When shopping for a home loan, you’ll likely come across the terms annual percentage rate and interest rate. While they might sound similar and are sometimes used interchangeably, they are different ways of understanding how much your mortgage costs. Comparing APRs and interest rates will help you navigate your mortgage options.

At a glance: Mortgage interest rate vs. APR

Here’s a quick breakdown of how interest rate and APR differ:

• Interest rate refers to the percentage of your loan you’ll repay the lender as the cost of borrowing.
• APR includes the interest rate plus any additional loan fees and costs, offering a more complete picture of the loan’s overall cost.
• Both interest rate and APR matter when you’re comparing loan offers. Looking at just one doesn’t give you the whole story.
• These terms apply to various loans, such as mortgages, home equity loans, and personal loans, but APR is less relevant when it comes to credit cards or home equity lines of credit, also known as HELOCs.

What is an interest rate?

Your interest rate is the percentage of your loan you pay the lender to borrow their money. If you have a mortgage, your interest rate might be fixed, meaning it stays the same for the entire life of the loan. If you have an adjustable-rate mortgage, or ARM, your interest rate will adjust from time to time based on market conditions.

You’ll always see your interest rate expressed as a percentage. You’re responsible for repaying the loan principal and the interest that accrues. When you add together the APR, the principal, and some closing costs, you get the total cost of the loan. Closing costs aren’t always included in the APR.

How interest rates work: An example

Your mortgage payments are amortized, which means that each payment is divided between principal and interest so that the loan will be fully repaid by the final payment. In practice, this means most of your payment goes toward interest at the start of your mortgage term. Over time, the amount you pay in interest decreases, and more of your payment is applied to the principal. By the end of the loan term, most of your payment goes to the principal, and a small part pays interest.

Let’s say you borrow $400,000 to buy a home with a 30-year fixed mortgage at 7% interest. Your monthly payment will be $2,661, which comes to $31,934 a year. In your first year of payments, you’ll pay $27,871 in interest, with the remaining $4,063 applied to your principal. In the final year, you’ll pay $1,179 in interest and $30,756 toward principal.

In short, amortization helps explain why your fixed-rate mortgage can feel “lighter” on interest over the years, even though the interest rate itself never changes.

What is APR?

APR stands for annual percentage rate, and it includes the loan's interest rate and any additional costs, such as prepaid interest, private mortgage insurance, or PMI, for conventional loans, certain closing costs, mortgage points, and lender origination fees.

So, why does APR matter? Because it helps you understand the true overall cost of the loan. When comparing loan offers, the APR gives you a more accurate, side-by-side view of the total cost of a loan. A mortgage with a slightly higher interest rate but lower fees could be cheaper than one with a lower rate and higher fees. Comparing APRs will show you which one is overall less expensive.

What's the difference between interest rate and APR?

A loan’s interest rate shows the basic cost of borrowing money, but the APR gives you a more complete picture of the loan’s total cost. Because APR includes not just the interest rate but also additional fees and charges, it usually is a larger percentage than the interest rate alone.

Thanks to the Truth in Lending Act, mortgage lenders must disclose both the interest rate and the APR up front. You’ll find this information on your Loan Estimate, which the lender must provide within 3 days of receiving your mortgage application, and on your Closing Disclosure, which you’ll receive at least 3 days before closing. If you aren’t provided this information, you should be suspicious of the loan’s offer and look for signs of a real estate scam.

How are interest rates calculated?

Your lender calculates interest rates using your financial data and a formula. Every lender uses its own formula. When calculating your rate, lenders consider current market interest rates, the overall state of the economy, and the real estate market. Shopping around will allow you to compare interest rates and choose the best offer.

How to get a lower interest rate

There’s more than one way to get a lower interest rate on a mortgage. Anything you do to lower the risk for your lender usually will lower your rate. This means your financial profile, including your credit score, debt levels, and down payment, plays a part in what you’re offered.

Raise your credit score

The first action you can take toward lowering your interest rate is to raise your low credit score, if needed. Your credit score is a three-digit number that represents how you use credit. A high credit score means you make payments on time and don’t borrow more money than you can afford to pay back. 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 you put on credit cards.
• Pay down as much of your debt as possible.
• Avoid applying for new loans when you’re preparing to get a mortgage.

Get a government-backed loan

You can often get a lower interest rate by choosing a government-backed mortgage, like a VA loan, FHA loan, or USDA loan, over a conventional loan. Government-backed loans tend to have lower interest rates compared with conventional loans. They also come with added benefits. For example, if your home goes into foreclosure and you have a loan insured by the federal government, the government agency backing your loan will reimburse your lender.

This extra protection reduces the lender’s risk, which is why they’re often able to offer you a lower rate. Plus, many of these loans come with more flexible credit and down payment requirements, making them accessible to a wider range of borrowers.

Can I lower my APR?

Unfortunately, you have less control over your APR than your interest rate. Your lender controls the other factors that go into your APR, like origination costs and broker fees. Though there are some ways to lower your APR, such as avoiding PMI by offering at least 20% down, the best way to secure a better rate is to compare lenders. 

When looking at mortgage APRs, be sure to compare apples to apples. Don’t compare the APR on a 30-year fixed-rate mortgage with the APR on a 5/1 ARM, since these loans aren’t the same.

The bottom line: Interest rates work with APR

While your interest rate is the percentage of the principal balance you pay on a loan, your APR includes your interest rate and other fees or expenses you’ll pay to your lender. APR provides a more complete look at the cost of the loan. This makes it an essential tool for comparing offers, revealing the true long-term cost beyond just the advertised rate.

Understanding your APR and interest rate is crucial when taking out a mortgage for purchasing or refinancing a home. Are you ready to calculate your potential interest rate and APR for a home loan? Get started online today.