APR Vs. Interest Rate: What’s The Difference?

You might encounter the terms “APR” and “interest rate” when shopping for a home loan. It’s easy to get confused and use them interchangeably, because your interest rate and your APR serve similar functions. However, interest rate and APR have a few differences you should be aware of.

Let’s learn how to calculate APR versus interest rate, as well as how to compare lenders so you understand the differences before you get a mortgage.

At A Glance: Mortgage Interest Rate Vs. APR

Here’s a quick summary of the differences between interest rate and APR. After this, we’ll explain some of the finer details, including the “other costs” associated with APR.

• Interest rate is the percentage of your loan that you’ll pay back to a lender. This percentage is part of the cost of borrowing money.
• A loan’s APR, or annual percentage rate, includes the interest rate along with other costs paid to acquire the loan. APR is a more accurate snapshot of a loan’s true cost than interest rate alone.
• Both interest rate and APR are important to consider when evaluating loan offers.
• Interest rate and APR are relevant to several loan types, including mortgage loans, home equity loans and personal loans. APR isn’t as relevant for credit card accounts and home equity lines of credit (HELOCs).

What Is Interest Rate?

Your interest rate is the percentage you pay to borrow money from a lender for a specific period of time or on a line of credit such as a credit card. Your mortgage interest rate might be fixed, meaning it stays the same throughout the life of the loan. On the flipside, your mortgage interest rate might be variable, meaning it will change periodically based on market rates.

You’ll always see your interest rate expressed as a percentage. You’re responsible for paying back the initial loan amount you borrow (your principal) plus any interest that accumulates on your loan. The APR plus the initial loan amount and some closing costs that may not be included in the APR make up the total cost of a loan.

How Interest Rates Work: An Example

Suppose you borrow $100,000 to buy a home and have a fixed interest rate of 4%. That means you’ll annually pay interest that is 4% of your principal loan balance.

At the start of your loan term, that would come out to $4,000 annually, or about $333.33 monthly. But as you go further into your loan term and chip away at your principal balance through regular monthly payments, you’ll owe less in interest and a larger portion of your payment will go toward your principal loan amount – even though you still have an interest rate of 4%.

This process is called mortgage amortization.

What Is APR?

APR stands for “annual percentage rate.” Your APR includes your interest rate as well as additional fees and expenses associated with taking out your loan. These fees and expenses include any prepaid interest, private mortgage insurance (with a conventional loan), some closing costs, mortgage points (also called discount points) and origination fees.

What Is The Difference Between Interest Rate And APR?

The main difference between a loan’s interest rate and APR is that interest rate represents the cost you’ll pay each year to borrow money, while APR is a more extensive measure of the cost to borrow money and it takes additional fees into account. Since APR includes your interest rate and other fees connected with your loan, your APR will reflect a higher number than your interest rate. You can also consider APR to be your effective rate of interest.

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 your Loan Estimate (which you’ll typically receive around 3 days after filling out your mortgage application) and your Closing Disclosure (which you’ll receive at least 3 days before closing on your home).

Remember to consider both the interest rate and the APR when deciding on the best mortgage loan option for you.

How Are Interest Rates Calculated?

Your lender calculates your interest rate using your personal data. Every lender uses its own formula to determine how much you’ll pay in interest. It’s therefore possible to get up to a total of 10 interest rates from 10 mortgage providers.

When calculating your rate, lenders also take into account factors such as current market interest rates and the overall state of the economy and real estate market.

How To Get A Lower Interest Rate

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 your score presents by offering you a higher interest rate.

There’s more than one way to secure a lower interest rate from your mortgage lender. Anything you do to lower the risk for your lender will usually lower your rate. Let’s explore a few ways to get a lower interest rate.

Raise Your Credit Score

The first action you can take toward lowering your interest rate is to raise your credit score, which is a three-digit number that provides lenders an at-a-glance summary of how you use credit. If you have a high credit score, it means you usually 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

In many cases, you can also lower your interest rate by choosing a government-backed loan – a VA loan, FHA loan or USDA loan – over a conventional loan, which isn’t government-insured. If your home goes into foreclosure and you have a loan that’s insured by the federal government, the government agency backing your loan will reimburse your lender.

Keep in mind that mortgage insurance can factor into your payment with both conventional loans and some government-backed loans, so it’s important to weigh all your options.

How Is APR Calculated?

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 private mortgage insurance by offering at least 20% down, the best way to secure a better rate is to compare lenders. 

When using APR to look at rates, be sure to compare apples to apples as far as loan programs. In other words, don’t compare the APR on a 30-year fixed-rate mortgage with one lender and a 5/1 adjustable rate mortgage (ARM) with another, since these don’t represent an equal comparison.

The Bottom Line On Interest Rate Vs. APR

While your interest rate is the percentage of the principal balance that you pay on a loan, your APR includes not only your interest rate but also various other fees or expenses you’ll pay your lender. As a result, APR provides a more all-encompassing look at the cost of the loan.

Some of the most common additional fees included in APR are brokerage fees, PMI and discount points.

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.