Interest rate vs. APR: What’s the difference?

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Real Estate

Interest rate vs. APR: What’s the difference?

When borrowing money, the first rule should always be to search for the lowest interest rate because borrowing costs can vary widely by lender and loan type. Credit cards are notorious for charging astronomical interest rates to some while offering 0 percent loans to others. Auto loans are not much better. Yet, when it comes to mortgages, consumers are rate conscious. But there’s more to consider than just the rate. The annual percentage rate, or APR, is also an important factor. What’s the difference, you ask? let’s break it down.

Interest rates vs. APR

The interest rate is the cost of borrowing the principal amount over time while the APR is that cost including fees. If you’re buying a house, you’ll notice there is an origination fee, sometimes there’s mortgage insurance, and discount points. All of those fees are prorated and paid over the life of the loan. So, the APR is the interest rate + other costs associated with borrowing money.

Don’t be alarmed when your mortgage broker quotes one number as your interest rate and a higher number for your APR. As a rule of thumb, the APR is usually higher than your interest rate.

For example, let’s say you’re pre-approved for a mortgage amount of $200,000 at 4.2 percent as your interest rate. That means you would pay $8,400 annually, or $700 per month, in interest. But, let’s say you have to pay mortgage insurance of $150 per month, plus $5,000 in closing costs. Add those fees ($6,800) to the principal amount of $200,000 to get the true amount that you’re financing, $206,800. The APR would be 4.34.

Be careful, though, if you’re shopping for an adjustable rate mortgage, ARM, the APR doesn’t include the maximum interest rate of the loan. Because the interest rate on ARMs move after a certain period of time based on contractual terms, the APR will shift. When shopping, compare ARMs to ARMs and fixed-rate mortgages with other fixed-rate mortgages.

Fortunately, your lender will have to disclose all fees, your interest rate and the APR on the consumer loan agreement as required by The Federal Truth in Lending Act.

Mortgage interest rates

We always hear about interest rates whether they’re moving higher or lower. Watching how the The Federal Reserve tweaks rates has become a sport, of sorts. It’s important to know that all of that Fed rate-watching hullabaloo doesn’t impact the rate you’ll pay for your mortgage — at least not directly. Mortgage rates are determined based on the individual applicant. Lenders charge higher interest rates for applicants with poor credit scores, high debt levels in comparison to their income, and other factors. Remember, the lender is making a long-term bet on you, the applicant. As most homeowners tend to opt for the stability of a 30-year fixed-rate mortgage, the rate you pay is based on the lender’s calculated risk.

Basically, your mortgage payment breaks down into two components: principal and interest. You’ll pay a little bit of principal in the beginning, however, most of your initial mortgage payments will go to pay interest. If you’re one of those people who want to pay down their mortgage as fast as possible, pay more than your stated monthly payment. Most mortgages these days do not have a pre-payment penalty. If you make an additional payment a year, or an extra $100 per month, that overage will reduce your principal balance which means you’ll pay less over the life of your loan.