Friday, 23 October 2020

APR vs Interest Rate: Understanding the Difference

APR vs Interest Rate: Understanding the Difference
03 Jul

It’s common for homebuyers to focus on interest rates while shopping for a mortgage, however, there’s another number that might even be more important.

While a low interest rate is appealing and directly impacts your monthly mortgage payment, it’s also important to look at each loan’s annual percentage rate, which provides a clearer picture of how much the loan will cost you when other fees are factored in.

The APR includes the interest rate as well as other fees and costs, and is expressed as a percentage. The interest rate only includes interest paid to the bank.

The difference between mortgage APRs and interest rates

An annual percentage rate (APR) is a broad measure of what it costs to borrow a loan. It includes the interest rate as well as other fees and costs.

The difference between an APR and an interest rate is that an APR gives borrowers a truer picture of how much the loan will cost them. Although an APR is expressed as rate just like interest, it is not related to your monthly payment — which is calculated using only the interest rate. Instead, an APR reflects the interest rate along with fees and other one-time costs a borrower will pay to get a mortgage.

“You can find a mortgage that has a 4% interest rate, but with a bunch of fees, that APR may be 4.6% or 4.7%,” said Todd Nelson, senior vice president of strategic partnership with online lender LightStream. “With all of those fees baked in, they are going to swing the interest rate.”

For example, one lender may charge no fees, so the loan’s APR and interest rate are essentially the same. The second lender may charge a 5% origination fee, which will increase the APR on that loan.

How APRs impact mortgages

Lenders calculate an APR by adding fees and costs to the mortgage interest rate and creating a new price for the loan. Let’s look at an example:

A lender approves a $100,000 mortgage at a 4.5% interest rate. The borrower decided to buy one discount point, which costs $1,000, to get the 4.5% rate (a discount point is a fee paid to the lender in exchange for a reduced interest rate). The loan also includes $900 in fees, which are being financed in the mortgage.

With the fees and costs mentioned above added to the loan, the adjusted starting mortgage balance becomes $101,900. The monthly payment (which consists of the principal plus interest) is then $516.31 with the 4.5% interest rate, compared with $506.69 if the balance had remained at $100,000.

To find the APR, the lender returns to the original loan amount of $100,000 and calculates the interest rate that would create a monthly payment of $516.31. In this example, that APR would be approximately 4.661%.

APRs will vary between lenders, as no two lenders are exactly alike. Some may offer competitive interest rates, but then tack on expensive fees and costs. Lenders with the same interest rate and APR probably aren’t charging any fees on that loan, and lenders that offer APR and interest rates that are close are likely charging a lower amount of fees and extra costs.

In short, APR gives you a way to compare two lenders offering the same interest rate so you make the smartest possible decision about your mortgage.

What factors influence an APR?

APRs change as interest rates fluctuate, but they’re more impacted by lender costs and fees. Below are some of the common charges that affect APRs:

  • Discount points: Lenders allow buyers to purchase points in return for a lower interest rate. The cost of a point is equal to 1% of the mortgage amount and typically lowers the interest rate on the loan by an eighth of a percentage point. For example, a buyer approved for a $100,000 loan could buy three points, at $1,000 each, to lower the interest rate from 4.5 to 4.125.
  • Loan origination fees: Loan origination fees typically average about 1% of the loan amount. This cost can be especially significant for larger loans.
  • Loan processing: This fee, which some lenders will negotiate, pays for the cost of processing a mortgage application.
  • Underwriting: These fees cover an underwriter’s review of a loan application, including the borrower’s income, credit history, assets and liabilities and property appraisal, to determine whether the lender should approve the loan application and what terms should be applied to the loan.
  • Appraisal review: Some lenders pay an outside reviewer to make sure an appraisal meets underwriting standards and that the appraiser has submitted an accurate report of the home’s value.
  • Document drawing: Lenders often charge a fee for creating mortgage documents for a loan.

Closing costs that aren’t commonly in an APR calculation are notary fees, credit report costs, title insurance and escrow services, home appraisal, home inspection, attorney fees, document preparation and recording fees.

Because an APR includes a loan’s interest rate, rising interest rates will increase the APR for several products including mortgages, auto loans and other types of loans and credit.

How interest rates affect mortgages

A mortgage interest rate is the rate a lender uses to determine how much to charge a homebuyer for borrowing money. Mortgage rates can either be fixed or adjustable.

Fixed mortgage rates don’t change over the life of a loan. For example, if you take out a 30-year loan at a 4.25% interest rate, that rate will stay the same — regardless of changes in the economy and market index — until the loan is paid off.

On the other hand, adjustable-rate mortgages (ARMs) will fluctuate as market conditions change after an introductory period, often set at five or seven years. That means your interest rate could go up or down depending on the economy, which will in turn raise or lower your mortgage payments.

ARMs often start with a lower interest rate than a fixed-rate mortgage, but can dramatically increase after the intro period ends.

If you are considering an ARM, it’s important to talk to lenders first about what an adjustable rate could mean for your monthly mortgage payments. Be sure to ask the following questions:

  • How long is the introductory fixed-rate period?
  • How often does the interest rate adjust after the fixed-rate period ends?
  • How does this loan compare to fixed-rate mortgage options?
  • How much will the monthly payment and interest rate increase with each adjustment?
  • What is the cap on how high or low the interest rate can go?
  • Is the monthly payment still affordable if the interest rate reaches the maximum allowed under the loan contract?

What factors influence an interest rate?

Don’t be surprised if a lender’s mortgage rate is higher than what was advertised. Each loan’s interest rate is primarily determined by market conditions and by the borrower’s financial health. There are several factors that help determine your rate, including:

  • Your credit score: Borrowers with higher credit scores generally receive better interest rates.
  • Your down payment: Lenders may offer a lower rate to borrowers who can make a larger down payment, which often is an indicator that the borrower is financially secure and more likely to pay back the loan.
  • The loan term: The number of months you agree to pay back the loan can make a difference. Generally, a shorter-term loan will have a lower rate than a longer-term loan — but higher monthly payments.
  • The loan amount: Interest rates can be different for loan amounts that are unusually large or small.
  • The loan type: While many borrowers apply for conventional mortgages, the federal government offers loan programs through the FHA, USDA and VA that may have lower interest rates.
  • The location of the property: Interest rates are different in rural and urban areas, and can also vary by county.

Below, we use LendingTree’s mortgage calculator to illustrate how interest rates can affect monthly mortgage payments.

Loan amount $250,000 $250,000
Interest rate 3.84% 4.20%
Monthly payment
(Principal and interest)
$1,170.59 $1,222.54
Interest paid after five years $8,651.39 $9,517.96

As shown above, an interest rate increase of even less than a half-percent could bump your monthly payment up by nearly $52, and your interest paid over the first five years by more than $800.

What about APRs on ARMs?

The annual percentage rate on an adjustable-rate mortgage won’t apply for the life of the loan, since the interest rate and monthly payment will change as the economy fluctuates. The APR only applies during the loan’s initial fixed-rate period, and no one can predict how much the rate will increase in the years that follow.

For example, a 7/1 ARM has a fixed interest rate for the first seven years that is determined by the market conditions on the day the loan was closed. After seven years, the interest rate will adjust annually, based on the movement of the index the ARM is tied to, which is commonly the one-year LIBOR.

The new rate likely won’t be the same as it was when the loan was originated. Mortgage rates fluctuate daily, and no economic forecaster can accurately predict how the index will change in the future.

The bottom line

While lenders often push their low interest rates when they advertise loans, Nelson said it’s vital that consumers check APRs when shopping around, and pay attention to how loan advertisements are worded. Lenders may advertise “no hidden fees,” he said, but that might just mean there are other fees that simply aren’t hidden.

“Look for a lender that’s transparent about disclosing all of those fees,” Nelson said.

Ask for clarity about any cost estimates you don’t understand, and try to negotiate lender fees where possible.

This article contains links to LendingTree, our parent company.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Marty Minchin

Crissinda Ponder


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