Difference Between Interest Rate and APR

Difference Between Interest Rate and APR

If you haven’t already seen it, you will soon; your Annual Percentage Rate, or APR. This number is one of the most confusing numbers on all the documents your lender provides and might also be the one number that your loan officer sometimes clumsily tries to explain. But really, the APR is quite simple when you understand the mechanics.

Some say that the APR is unimportant, that it’s just an insignificant number and to not pay any attention to it. But that’s only said by those who don’t understand its meaning. The Annual Percentage Rate is properly defined as “the cost of money borrowed, expressed as an annual rate.” That’s it. So what do you do with it? You use it to compare the same loan offering from competing lenders, in this instance a VA Loan from lender A and a VA loan from lender B.

The Note Rate is the first ingredient in the APR calculation. That’s the rate on which your monthly payment is based. If you have a loan amount of $100,000 on a 30 year fixed rate mortgage with a rate of 4.00 percent, your monthly payment is $477. Regardless of what your APR number might say, your payment is $477 with a 4.00 percent rate. So where does the APR come into play?

APR vs. Interest Rate

APR Interest Rate
APR is a broader measure of the cost of a mortgage. It includes the interest rate plus other costs such as broker fees, discount points and some closing costs, expressed as a percentage. The interest rate is the cost of borrowing the principal loan amount. The rate can be variable or fixed, but it’s always expressed as a percentage.

Why These Numbers Matter in a Mortgage

Since APR includes both the interest rate and certain fees associated with a home loan, APR can help you understand the total cost of a mortgage if you keep it for the entire term. The APR will usually be higher than the interest rate, but there are exceptions.

One is a no-closing-cost refinance: In this case, the interest rate and APR will be the same.

Another is an adjustable-rate mortgage (ARM). The APR for an ARM will sometimes be lower than the interest rate. This can happen in a declining interest rate environment when lenders can assume in their advertising that your interest rate will be lower when it resets than when you take out the loan.

However, the APR on an adjustable-rate mortgage is only an estimate, because no one can predict what will happen to interest rates over your loan term. Your APR on an ARM will only be knowable after you’ve paid off the loan.

Which Loan Is Cheaper? Interest Rate vs. APR

Loan 1: $200,000 principal 3.00% fixed interest rate $10,000 fees 3.40% APR Loan 2: $200,000 principal 3.40% fixed interest rate $4,000 fees 3.56% APR
Time into loan Total costs [(interest+principal)*months]+ fees Total costs [(interest+principal)*months]+ fees Difference
3 years ($843*36) + $10,000 = $40,348 ($886*36) + $4,000 = $35,896 $4,452: Loan 2 is cheaper
5 years ($843*60) + $10,000 = $60,580 ($886*60) + $4,000 = $57,160 $3,420: Loan 2 is cheaper
7 years ($843*84) + $10,000 = $80,812 ($886*84) + $4,000 = $78,424 $2,388: Loan 2 is cheaper
10 years ($843*120) + $10,000 = $111,160 ($886*120) + $4,000 = $110,320 $840: Loan 2 is cheaper
11 years, 8 months ($843*140) + $10,000 = $128,020 ($886*140) + $4,000 = $128,040 $20: Loan 1 is cheaper
15 years ($843*180) + $10,000 = $161,740 ($886*180) + $4,000 = $163,480 $1,740: Loan 1 is cheaper
30 years ($843*360) + $10,000 = $313,480 ($886*360) + $4,000 = $322,960 $9,480: Loan 1 is cheaper

Is a Lower Interest Rate or Lower APR Better?

The answer to this question depends on what is more important to you: the lowest possible monthly mortgage payment or the lowest possible total loan cost.

Focus on the interest rate if the monthly payment is your priority and the APR if the overall loan cost is your concern.

If you plan to live in your home for 30 years, a low interest rate might be the most important factor. You might be willing to pay points that will lower your interest rate but increase your APR.

What Fees Are Included in Mortgage APR?

Federal law requires lenders to include these charges in a mortgage APR:

  1. Interest

  2. Points

  3. Loan origination fee

  4. Broker fee

  5. Mortgage insurance

APR may also include prepaid interest, any loan application fee, any underwriting fee and other lender charges.

Federal law says lenders should not include these finance charges in a mortgage APR:

  1. Title examination and title insurance fees

  2. Closing agent’s loan document preparation fees

  3. Escrowed amounts for property taxes and homeowners insurance

  4. Notary fees

  5. Home appraisal fees

  6. Pest inspection fees

  7. Flood hazard determination fees

  8. Credit report fees

  9. Settlement or escrow agent fees

  10. Attorney fees

  11. Government-imposed recording fees

  12. Government-imposed property transfer tax

All of these fees are third-party fees: The money you pay for them does not go to the lender. It goes to the title insurance company, the notary, the home appraiser and so on. That said, lenders often select affiliated service providers that they have a financial incentive to work with.

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