The Difference Between the Interest Rate and the Annual Percentage Rate (APR)
Getting a mortgage requires hearing a lot of industry lingo from a bunch of different sources before, during, and sometimes even after closing. With escrows, liens, and any given number of acronyms, it’s no wonder people hire full-service agents to handle all of the details of buying or selling a home. The home finance world is packed to the brim with words and concepts that a home buyer should definitely know, but often won’t until the very last minute of a mortgage transaction.
Of the most important things that a home buyer should pay attention to during the mortgage process are the terms associated with the cost of the loan. As you probably know, borrowing money to purchase a home isn’t free, nor is it cheap. If you want to borrow money from a bank or lender, they’ll require a little bit of profit to compensate for their time and risk. This is known as interest.
No home loan comes without an interest rate tied to it. This number represents the percentage of the loan amount that the home buyer will be charged for borrowing money. It’s actually one of the first things that a mortgage loan officer will discuss with a potential borrower.
But, before a home buyer can even get comfortable with their interest rate, the term APR typically pops up almost immediately after the interest rate discussion is settled. APR or “annual percentage rate” is another percentage that a home buyer should definitely keep an eye on when it comes to getting a mortgage. If the interest rate dictates the charge for borrowing the principal loan amount, then the APR represents the overall cost of the loan, when all other charges are factored in.
Unfortunately, the APR discussion leaves many home buyers confused as to what exactly they will be expected to pay. They might also be wondering why there are two different types of rates, to begin with. With that in mind, we certainly think it’s worthwhile to understand the differences between a mortgage’s interest rate and its APR. But first, it’s important to understand what each term means individually.
What is the Interest Rate on a Mortgage?
Every mortgage loan product is sold with a rate of interest that dictates the cost of borrowing that sum of money. Interest is paid as a portion of each and every monthly payment, often on an amortization schedule. Typically, the interest portion of the payments earlier on in the loan term is much larger and slowly decreases as the term progresses.
The interest rate that a homeowner is expected to pay depends on a number of factors including (but not limited to) the type of loan, the credit score of the borrower, and even the prime rate, which is the best interest rate at which banks will lend money to their higher tier clients. A higher interest rate means that a borrower will be paying more for the amount borrowed. This is why it is important for home buyers to shop around for lenders and loan products that have the lowest possible interest rates available.
What is Annual Percentage Rate (APR)?
The annual percentage rate is yet another percentage that has to do with a loan’s affordability, yet it isn’t a rate that you must pay, it’s more of a summary of a borrower’s total cost. Since APR takes more factors into consideration in determining a loan’s cost, the calculation for APR goes beyond the principal loan amount.
As part of the Truth in Lending Act, lenders are required to disclose the total cost of the loan as part of a mortgage transaction. This is done as part of their TILA-RESPA integrated disclosures. Instead of simply calculating the interest rate for the principal amount, the annual percentage rate also incorporates any discount points that the buyer may have purchased, broker fees, and many of the additional costs and fees of the mortgage transaction. APR is the best representation of exactly how much a borrower will pay over the course of the mortgage.
Still, home buyers would do well to inquire about which fees are calculated in the APR of a loan of interest. For example, some lenders do not include the fees associated with home appraisals or home inspections, even though these are standard closing costs in the home purchase process. Upfront fees are important to keep track of as well when determining the affordability of a home loan.
The Differences Between APR and Interest Rates
Now that you know more or less what each term represents, it should be easier to understand the differences between the two. For starters, the major difference is that the interest rate is a charge based solely on the amount of money being borrowed, while the APR is a broader view of the entire cost of a mortgage transaction after various factors are added to the equation. The interest rate on a home loan is one of the aforementioned factors of determining APR.
While it’s extremely prudent to find the lowest interest rate when shopping for a mortgage, it is also essential to make sure the APR is within reason as well. Lenders can calculate APR pretty accurately since they are aware of all of the extra costs and fees that will be charged on their end. It’s important to remember that APR doesn't determine the value of the monthly payments, it merely shows the overall amount that a borrower will spend on the loan.
After all, Interest rates can be negotiated or bought down, and some are even variable to begin with. Still, interest rates are an important part of APR, which looks at mortgage points and fees that get rolled into the loan amount and which add to the sum that must be repaid by the end of the loan term. It helps to think of your monthly payments when it comes to the interest rate, and the total amount paid at the end of the loan term for the APR.
In that respect, borrowers should be comparing both figures when looking at different loan packages. Getting a low-interest rate is important, but if the APR for a loan is much higher when compared to a similar loan package, then you could be paying thousands, if not tens of thousands more to borrow the same amount. In addition, if you have enough out-of-pocket money to buy down the interest rate on a loan, you should also see how that affects the APR before determining whether it is worth the money.
How to use APR and Interest Rates to your Advantage
The most important takeaway here is the awareness of what each term represents. However, many may still wonder why it is important if they can just look for loans with low monthly payments. To be fair, it really all depends on time.
You see, making the most out of the knowledge of APR and interest and what they mean to a potential borrower depends highly on the amount of time a home buyer wishes to stay in a home. For borrowers who do not intend to live in the home for the duration of the loan term, obtaining a low-interest rate is more important than getting a low APR. That being said, it also wouldn’t make much sense to waste a ton of money at closing buying down that rate either, since you wouldn’t be paying it for an extended period of time.
For home buyers looking to make that long-term commitment to a property, the APR is worth more consideration. You see, having affordable monthly payments is extremely important, particularly when you consider the looming possibility of foreclosure. Still, APR is the difference between paying back $360,000 vs. $340,000 on a $200,000 loan after 30 years. While that may not seem too impressive, that's still a difference of $20,000.
Every home buyer has a different ideal scenario, so it’s important to know what you hope to get out of a mortgage deal. If low monthly payments are considered a high priority, then the APR might not even matter to a borrower. If getting the best overall deal is important, then securing a loan with the lowest possible APR is likely the best strategy to follow.