Whenever you evaluate loan options, one of the first things you’ll see is each of their interest rates and annual percentage rates (APR).
It’s easy to conflate the two. After all, they’re both shown as percentages, and their figures are often close. Yet, each represents entirely different things. Knowing their differences can help you better evaluate each loan option and pick the one that saves you the most money.
To explore mortgage APRs vs interest rates, we’ll start by defining each.
Interest rate: The cost of borrowing money
When a bank lends you money, they make a profit by charging you more than the original loan amount. Any amount that exceeds the value of your loan (i.e. principal) is interest. An interest rate is the annual percentage of the loan amount you’re charged on top of principle.
For example, if you take out a loan for $100,000 and your interest rate is 4%, you’re charged $4,000 per year. You’ll likely be making mortgage payments every month, so you can expect to pay $4,000/12 = $333.33 per month in interest.
Note: As you pay down your principal over time, your interest charges will decline (assuming you have a fixed rate).
APR: A more comprehensive calculation
An APR calculates the annual cost of your loan by adding your interest rate with your loan origination fees, application fees, among other closing costs.
Since the APR takes additional costs into account, it’s higher than your interest rate.
Let’s calculate it by using the numbers from our earlier example, only now we’ll add $10,000 in closing expenses and clarify that the loan is for 30 years. To recap:
Loan amount = $100,000
Interest rate = 4%
Closing costs = $10,000
Loan term = 30 years
To get your APR, you’d use the following formula (fees in this case would just be our closing costs):
The formula is a bit overwhelming, right? You can skip the manual calculations and plug your numbers into this calculator to automatically get your APR.
Using the numbers from our example, your APR would be 4.81%, and your monthly payments would jump up to $525.16.
How would your APRs and interest rates look? Provide some basic info on this page and we’ll give you a couple loan estimates for free!
Mortgage APRs vs interest rates
Since the APR takes a more complete look at your loan costs, it’s worth using over the interest rate when comparing loan options.
That being said, there are a lot of other things you need to consider before you pick a loan option. Here are just some additional items to think about:
- The Loan term: Are you looking to pay back your loan over the course of 15 years? 30 years? Different term lengths can significantly affect your monthly payments and the amount of interest you owe.
- Adjustable vs fixed loan: Want the stability of paying a set amount every month? Then a fixed loan might be right for you. On the other hand, if you prefer to take more risk and have your rate either increase or decrease over time, depending on market conditions, then an adjustable rate mortgage (ARM) can be a good choice.
- Discount points and lender credits: Need help paying off the closing costs? You can buy lender credits. It’s simply when your lender foots a portion of the initial expenses in exchange for a higher rate. You can also do the opposite by buying points. Discount points raise your initial payments for a lower rate.
Interest rates and APRs are critical to evaluating your loan options—with APRs being particularly valuable. You can use both along with other considerations, like those mentioned above, to make an informed and confident decision on your loan.