What is the Difference Between My Interest Rate and APR?
Knowing the difference between your mortgage’s interest rate and APR (annual percentage rate) is not as confusing as it seems. Both rates relate to the total cost of your home loan, but each calculation comes from a subtle but distinct difference in inputs. It is important to understand the difference between an advertised rate and how your APR can diverge somewhat significantly from your interest rate if you are not careful.
The interest rate on a loan is the cost of borrowing the loan amount, or principal. The interest rate on a mortgage is always expressed as a percentage, but it can be at a fixed or variable rate. This rate is set and tracks with the federal funds rate set by the Federal Reserve (also known as the Fed). The federal funds rate is the rate at which banks lend money to other banks overnight.
Interest rates generally tend to lower during times of recession or economic concerns and increase during times of economic boom. While not a direct determination of the mortgage rate on one-to-one basis, the federal funds rate does influence the direction of mortgage rates.
In our example, John Doe picks a house to purchase for $300,000 at a rate of 4%. His annual interest expense would be $12,000. His monthly payment would be divided up into twelve months for a rate of $1,000/month.
Annual Percentage Rate (APR)
APR is a broad indicator of the cost of the mortgage, because it includes other costs and fees that the interest rate does not. Simply put, APR is the more effective indicator of the true cost of a mortgage because of this inclusion. Examples of the fees included in the APR are broker fees, closing costs, rebates and discount points.
The APR will just about always be greater than or equal to the interest rate. There are exceptions to this rule when the lender chooses to offer a rebate on a portion of the interest expense, but this circumstance is not common.
In the previous example for the interest rate, our friend John Doe had a 4% interest rate for his $300,000 purchase. If John adds his closing costs and other fees of $10,000 into the loan, the principal now becomes a new amount of $310,000. The 4% interest rate on the new principal equals an annual payment of $12,400 or roughly $1033.33/month. To determine the APR, divide the annual payment ($12,400) by the original loan amount of $300,000 to get an APR of 4.13%.
The bottom line of the APR is that any additional costs factored into the principal will increase the APR.
Considering Both the Interest Rate & APR
Comparing mortgage offers with both the APR and the interest rate are ways to determine the best choice for a mortgage. The interest rate is determined by economic conditions, the federal funds rate, and the borrower’s credit score. A higher credit score will generally lead to a lower interest rate, as the rate is a function of the risk on the mortgage for the lender.
APR is ultimately determined by the lender, since the largest factor is often the lender fee. The Truth in Lending Act (TILA) requires lenders to disclose the APR in every consumer loan agreement. However, even with this requirement, all lenders might not include all fees in the APR. Lenders are not required to include certain costs such as credit reporting, appraisal and inspection fees.
For this reason, you may want to ask your lender what is included in the APR calculation so that you can compare apples to apples. However, this is where a mortgage broker can come in handy and help you navigate this realm of APR and interest rates.
When seeking a mortgage, the bottom line is that APR and interest rates are the two factors that you want to focus on when it comes to costs. A higher APR can indicate that you are paying a larger amount of fees while the interest rate will help compare and understand monthly costs. Even a small change in either the interest rate or APR can lead to a significant change in your total costs.
Work with a mortgage broker like Range Lending to help you navigate the mortgage process and ensure the best rates available. We can help you chart the world of interest rates and APR to find the best deal for you.