Breaking Down the Difference Between Your Mortgage Interest Rate and the APR

There are several terms homebuyers need to know when shopping for a new mortgage loan.

Two of the most important are your mortgage interest rate and your annual percentage rate, also known as the APR. Even though most homebuyers know these terms on a surface level, the actual definition of each leaves some perplexed. If you think the mortgage interest rate and APR are similar, you’re right. However, there are differences you need to know in order to make the best decision for your new mortgage. Here’s what you need to know about mortgage interest rates and APRs.

What is the Mortgage Interest Rate?

Most borrowers know the interest rate on a new mortgage loan is the cost paid to the lender over time. You can think of this as the percentage fee you pay for borrowing money. Mortgage interest rates are applied to the loan balance to determine how much you owe back to the lender each month. For example, a $200,000 mortgage with a 30 year term and interest rate of 5.0% equals a monthly payment of $1,073.64. Part of that payment is the interest on the loan and the rest is applied towards your principal.  Although the monthly payment remains the same, the portion towards your principal becomes larger each month as the balance of your loan shrinks (this is called “Amortization”).

Mortgage interest rates vary from lender to lender, and from borrower to borrower. This is because the interest rate is based on your credit history and score, the amount of your new mortgage loan, and prevailing interest rates in the mortgage market. The higher the interest rate, the greater your monthly payment will be. Most homeowners understand this concept broadly, and most focus their attention on this percentage when shopping for a new loan. But if you want a true understanding of the cost of your mortgage, you need to look to the APR.

What is the APR?

A mortgage APR, or annual percentage rate, is also expressed as a percentage. However, the APR is a broader measure of the cost to borrow for a home purchase or refinance. It includes the interest rate, points, lender fees, and other charges to give a better idea of the total cost of the loan. Your APR on a mortgage is often higher than the interest rate because these charges are added into the calculation.

Figuring out the calculation behind an APR can be a bit confusing at first. To get to the percentage, lenders add in their fees, closing costs, and the interest rate charges, and then spread that total out over the life of the loan. For example, the same mortgage of $200,000 with an interest rate of 5% but with $3,000 in fees has an APR of 5.13%. The $3,000 is is deducted from your loan amount to determine the total amount financed. Because your payment is based on the higher, actual loan amount, this causes the APR to be higher in most cases than your actual Note Rate.

Why It Matters

The difference between your mortgage interest rate and APR is helpful to know when shopping for a new loan. Interest rates may be the same across several lenders, but APRs could vary widely depending on the fees charged by the lender. Closing costs also make a difference in the APR, which again, range pretty significantly from lender to lender. As a homebuyer, you should compare APRs, not mortgage interest rates alone, to see where you are getting the most bang for your home-buying buck.

Let’s look at a quick example.

The following chart offers fictional interest rates from three different lenders, closing costs and charges, and the final APR.

On the surface, you may be inclined to go with Lender 1 because the interest rate is lower than the other two options. However, the APR tells a different story. While a minimal difference, Lender 3 actually has the lowest total cost of borrowing. This is due mainly to its lower fees. You can see that paying close attention to the APR makes a difference!

The Bottom Line

Understanding your mortgage interest rate and APR makes it easier to know what you’re getting into for the long-term. While the calculations may be difficult to breakdown initially, your lender has you covered. That’s because all lenders are required to provide the APR in the disclosure for a new loan, along with the interest rate. You can easily compare rates and APRs side by side from lender to lender without feeling like you’re missing an important piece of the puzzle.

Be sure to check both interest rates and APRs on any offer for a new mortgage before signing on the dotted line.