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Understanding interest rate vs. APR

By Vance Edwards

December 2019

What’s an APR, or annual percentage rate, exactly? And what’s the difference between the APR and the interest rate of a mortgage? For many first-time homebuyers applying for a mortgage, the difference between the APR and interest rate is a mystery. (Most repeat homebuyers would probably admit that the distinction isn’t so crystal clear to them either.)

The irony around this confusion is that the APR was created to bring transparency and clarity to the mortgage process. And on top of that, comparing the APR can potentially be misleading, if you aren’t careful. More on that in a moment, but first let’s discuss the difference between the interest rate and APR.

What is the interest rate?

This is fairly straightforward: The interest rate is the annual cost associated with borrowing the money used to buy your home. Expressed as a percentage, it’s used to determine your monthly mortgage payment.

But the interest rate doesn’t include all the associated costs and fees you pay up front to obtain that mortgage – such as closing costs, discount points (sometimes paid to reduce the interest rate), loan origination fees and mortgage insurance.

That’s where the APR comes in. It’s intended to help you compare the different loan options from a lender or the different offers you receive from multiple lenders.

What is the APR?

The APR, or annual percentage rate, is meant to present a more comprehensive picture of the total cost of borrowing money to buy a house. While the APR is not used to calculate your monthly payment, it combines the interest rate with those upfront fees – closing costs, discount points, loan origination fees, mortgage insurance – into one percentage.

So how is the APR calculated? The upfront fees are divided as if they were paid each month and spread cross the life of the loan, then combined with the interest rate. So, for a 30-year fixed-rate mortgage, upfront fees would be divided over 30 years.

Where to find the APR and interest rate for a loan

The Truth in Lending Act requires lenders to provide you with both the interest rate and the APR, and lenders are also required to display an APR whenever they advertise an interest rate.

On the Loan Estimate you receive from a lender, look for the interest rate for the loan on page 1 and the APR on page 3. On the Closing Disclosure you’ll receive before the loan closes, you can find the interest rate on page 1 and the APR on page 5.

The challenge of comparing loans using APR

If you plan to use the APR to compare different loan options, make sure you’re comparing apples to apples. For example, don’t compare a fixed-rate loan to an adjustable-rate mortgage or a 30-year loan to a 15-year loan.

But even when comparing the same loan terms, the lowest APR does not necessarily mean the lowest total cost of borrowing.

Remember that APR calculations assume you’ll be paying off your loan over the full term. But while 30-year fixed-rate mortgages are the most common loans, very few of those loans will truly last 30 years. People move. They refinance. Some pay off the mortgage early. In those cases, the APR may not be the best way to assess the total cost of the loan, because its calculation is most accurate for borrowers who pay that loan for the full term (or close to it).

So, should you focus on interest rate, APR, or both?

If all you really care about is finding the lowest monthly payment, focus on the interest rate, because it will determine what you owe each month.

If you’re convinced that you found your dream home and will be in it for decades to come, the APR will help you compare the true cost of borrowing the money to fulfill that dream.

But what if you’re somewhere in between, like many of us? Of course you care about the monthly payment – but you also want to know the total cost of borrowing that money. And you realize you may decide to move 5 to 10 years down the road.

In that scenario, comparing the APR on different loans can be helpful, though the lowest APR may not necessarily represent the lowest overall cost. Think of the APR as a guide, but discuss with your lender the fees and costs associated with their mortgage offer. Be sure to ask questions until you feel comfortable you understand the answers and are ready to make an informed decision. 

Related to This

Rebecca Williams •

This definitely made me have a better understanding. Makes the process easier.

Mark •

This really helps

Tip Fishburn •

Good stuff here - I just refinanced down to a 15 Year Term recently and it was nice to see the gap narrow between my Interest Rate & my APR - funny how paying off loans in a shorter timeframe positively influences that calculation ;- ) - Thanks Vance !

Nikia Shields •

This information was extremely informative

Justin Taylor •

Good way to explain how Intrest Rates and APR works.

Stanley B •

The best answer I have found on the internet. Thank you!

Demarco Mcdaniel •

I need to do more research into this subject

Cecilia Bueso •

Thank you. I will try to play around with real numbers

Tara Magoon •

It was informative I have a better understanding between interest rates and APR. Tara

Angie •

Thank you

Mark Birr •

I now have a better understanding of the interest rate and the APR. Very informative.

David Jordan •

This information was very helpful and useful! I have a better understanding between the interest rate and the APR.

Daniel Retana •

Very educational.

Verdell Baker •

The loan rates depend on the APR and Interest rates. Understanding how they work could be a great access to you.

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Vance

Read more articles by Vance
Vance Edwards has been working to help get people into homes since joining MGIC back in 1999, after brief tours in the Army, college and a Milwaukee advertising company. He’s bought 3 homes (and sold 2) along the way, using them with his wife Carrie to raise 2 remarkable children, Hailey and Trevan. Vance loves baseball at any level, is part of a comedy sketch & improv team, and has won national playwriting awards.
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