APR versus interest rate: What's the difference?
If you’re applying for a mortgage, these are two financial terms you need to understand. APR stands for "annual percentage rate," or the amount of interest on your total loan that you'll pay annually over the life of the loan. It's slightly different from the interest rate, which is the cost you'll pay each day based on your mortgage balance.
These terms might be foreign to you, especially if this is your first time buying a home. But don’t worry—we’ll break down what each one is so that you’re ready to be a savvy mortgage shopper. Let's first start by discussing the mortgage interest rate.
What is a mortgage interest rate?
Simply put, the interest rate is the cost you will pay each day the borrowed money is owed, expressed as a percentage rate. In other words, “it does not reflect fees or any other charges you may have to pay for the loan.
Interest is calculated as a per diem (per day) figure based on the borrower's current outstanding mortgage balance. This means that every month you pay back a portion of the principal (the amount you’ve borrowed) plus the interest accrued for the month. Your mortgage lender will use an amortization formula to create a payment schedule that reflects your principal and interest on the loan.
What determines my mortgage interest rate?
Like gas prices, mortgage rates can fluctuate from day to day depending on changes in housing market conditions, says Jack Guttentag, author of "The Mortgage Encyclopedia." But even saving a fraction of a percent on your interest rate can save you thousands of dollars over the life of your mortgage.
Six key factors affect your interest rate:
- Credit score: Your credit scoreis a numerical
- representation of your track record of paying off your debts, from credit cards to college loans. Mortgage lenders use your credit score to predict how reliable you’ll be in paying your home loan. In general, consumers with higher credit scores receive lower interest rates than consumers with lower credit scores. A perfect credit score is 850, a good score is from 700 to 759, and a fair score is from 650 to 699.
- Loan amount and down payment: If you're willing and able to invest a large down payment in your home, mortgage lenders assume less risk and will offer you a better rate. (A 20% down payment makes a lender feel a lot more secure than a 10% down payment.) If you don’t have enough money to put down 20% on your mortgage, you will probably have to pay private mortgage insurance, or PMI, an extra monthly fee meant to mitigate the risk to the lender that you might default on your loan. (PMI ranges from about 0.3% to 1.15% of your home loan.) Also, depending on your circumstances or mortgage loan type, your closing costs and mortgage insurance may be included in the amount of your mortgage loan.
- Home location: Mortgage rates can vary depending on where you’re buying a home. Indeed, the strength of your local housing market can drive up or drive down interest rates.
- Loan type: Your interest rate will depend on what type of loan you choose. The most common type of home loan is a conventional mortgage, aimed at borrowers who have well-established credit, solid assets, and steady income. If your finances aren't in great shape, you may be able to qualify for a Federal Housing Administration loan, a government-backed loan that requires a low down payment of 3.5%. There are also U.S. Department of Veterans Affairs loans and U.S. Department of Agriculture Rural Development loans.
- Loan term: The duration of your loan affects your mortgage rate. In general, shorter-term loans have lower interest rates—and lower overall costs—but larger monthly payments.
- Type of interest rate: Mortgage rates depend on whether you get a fixed-rate mortgage or an adjustable-rate mortgage, or ARM. A fixed-rate mortgage means the interest rate you pay remains fixed at the same level throughout the life of your loan. Meanwhile, an ARM is a loan that starts out at a fixed, predetermined interest rate—likely lower than what you would get with a comparable fixed-rate mortgage—but the rate adjusts after a specified initial period—usually three, five, seven, or 10 years—based on market indexes.
What is an APR?
There are costs to obtaining a mortgage, says Jordan Dobbs, a loan officer at Washington First Mortgage in Rockville, MD. In a nutshell, Dobbs says, an APR is a broad measure of the cost to you of borrowing money, expressed as a percentage rate. It determines the total amount you pay annually over the life of the loan.
What determines my APR?
Because APR includes the interest rate offered on your mortgage, as well as discount points, mortgage origination fees, and other costs associated with obtaining a loan, it is usually higher—often 0.20% to 0.25% greater—than the interest rate. So, in general, the higher your APR, the higher your payments are over the life of your home loan.
Consequently, “it’s important to check both interest rate and APR when looking for a mortgage,” says Dobbs. If you’ve applied for a mortgage and received a good-faith estimate from a lender, you can find the interest rate on Page 1 under “Loan Terms,” and the APR on Page 3 under “Comparisons,” according to the Consumer Financial Protection Bureau.
APR vs. interest rate: Things to keep in mind
Pro tip: When lenders advertise APRs, they offer the rates under ideal conditions—meaning rates apply to borrowers with excellent credit and spotless documentation. Depending on your circumstances, the rates can be higher.
Moreover, lenders that offer low APRs often require high upfront fees; their points requirements, origination fees, and insurance payments might be unusually high in order to justify their lower rates.