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When you purchase a house, you will probably see two different interest rates, the mortgage interest rate and the Annual Percentage Rate. But what is the difference?
Both numbers represent the cost of borrowing money from the lender but are calculated differently. Understanding both terms when shopping for a mortgage is important so you can calculate exactly how much you will pay over the life of the loan.
What Is a Mortgage Interest Rate?
A mortgage interest rate is the percentage you pay to the lender in order to borrow the principal amount of the loan. The lender sets interest rates based on the current economy, the property, and your financial situation. For instance, they will look at:
- Credit score – a three number value that represents your payment history, utilized lines of credit, payment history, and credit inquiries, among other factors. Generally, the higher the credit score the better the interest rate.
- Credit and payment history – in addition to the credit score, the lender will likely want to see if you have defaulted on any loans or have any foreclosures of bankruptcies.
- Income – a lender will look at your income from employment, other investments, and from things like child support or alimony.
- Debt-to-income ratio – the amount of money you bring in as income each month is compared with the amount of debt you have to show the lender your debt-to-income ratio. For a conventional loan, the maximum debt-to-income ratio is usually between 45% and 50%.
- Employment – stability in employment is important to lenders because they want to ensure you will make mortgage payments regularly.
- Amount of down payment – the larger the down payment the less risk the lender is taking because of the lowered principal loan amount. Most conventional loans require a 20% down payment. There are government backed programs that only require 3% down. Some mortgage programs, like VA loans, require no down payment.
- Loan amount – if a mortgage amount exceeds the loan limits set by Fannie Mae and Freddie Mac it will be classified as a Jumbo loan, which is not a conventional mortgage. For example, in 2021 the loan limits are between $548,250 to $822,276 depending on the location of the home. A jumbo loan can have higher interest rates than conventional loans.
There are many factors that go into determining a mortgage interest rate. It is always smart to compare different lenders to make sure you are getting the best rates.
What is an APR?
The APR for a mortgage differs from the mortgage interest rate because it includes additional fees and expenses associated with taking out the loan. It should be equal to or higher than the mortgage interest rate, depending on the fees. If the APR is more than .25% higher than the mortgage interest rate, it would be wise to investigate what the lender includes in the APR.
APR is a better representation of the interest rate you will pay over the life of the loan. For example, if your mortgage interest rate is 3.5% but your APR is 3.75%, you will pay .25% more than the mortgage interest rate suggests over the time you have the loan. This is assuming you have a fixed-rate mortgage, which we will discuss later in the article.
Fees that are sometimes included in the APR include:
- Private Mortgage Insurance (PMI) – insurance required on conventional mortgages with less than 20% equity.
- Brokerage fees – if you use a mortgage broker, this is the amount they charge for facilitating the loan.
- Discount points – lenders sometimes offer the option for a lower interest rate by paying an upfront fee for discount points. For example, for every 1% of the loan amount paid upfront the interest rate is reduced .25%.
- Prepaid interest – interest you pay at closing that covers the interest amount from the closing date through the end of the month.
- Escrow fees – the escrow company is who makes sure everyone is paid appropriately for the mortgage transaction. This fee is calculated based on the loan amount.
- Loan processing fee – the amount the lender charges for processing the mortgage loan.
This is not an exhaustive list of items included in the APR but discusses some of the most common. Additional fees sometimes added to the APR include underwriting fees, document preparation, and administrative fees.
There are also costs that are not included in the APR. These include:
- Credit report
- Appraisal fees
- Document preparation
- Attorney and notary fees
- Title costs
- Home inspection
Lenders are required to tell you both the mortgage interest rate and the APR, and if you are interested in the specifics, you should be able to get a list of what is included in the calculation.
Are the Interest Rate and APR Fixed?
There are two different types of mortgages, fixed rate and adjustable-rate mortgages (ARM).
Fixed-rate mortgage – a fixed rate mortgage has the same mortgage interest rate over the life of the loan. For instance, you might see a 30-year-fixed loan term with a 3.25% mortgage interest rate and a 3.75% APR.
Adjustable-rate mortgage (ARM) – an ARM has a mortgage interest rate that changes over the life of the loan. There is usually an introductory period with an attractive interest rate and then the mortgage interest rate adjusts at set intervals. A common ARM is a 5/1 mortgage. For a 5/1 loan the introductory rate lasts for 5-years and then adjusts every year after that for the life of the loan.
Both fixed-rate and ARMs are based on the mortgage interest rate. The APR is generally only shown at the beginning of the loan process to help you compare lenders and how much you will pay over the life of the loan.
The APR is most accurate for fixed-rate mortgages, because with an ARM the interest rate changes over time, which means the APR would also change.
What is More Important: Interest Rate or APR?
The APR is the true cost of borrowing money for a loan, and so it is important to consider.
For example, if you have a 30-year-fixed mortgage for $300,000 with a 4% interest rate, the monthly principal and interest payment would be $1,432. However, let’s say there are additional fees of .25% bringing the APR to 4.25%. The monthly principal plus interest payment would be $1,476.
So, in addition to the true cost of borrowing the money for a mortgage, the APR will also give you a better idea of what you need to budget monthly.
How Can I Compare Interest Rates and APR?
Because of the Truth In Lending Act, lenders must provide you with both the interest rate and APR. When you are comparing lenders, it is important to ask for both numbers.
The Bottom Line
Ultimately, the APR is the true amount you are borrowing if you complete the loan term. It gives a more realistic view of the true cost of financing. The mortgage interest rate is the percentage it will cost you to borrow the principal amount of the mortgage. Comparing lenders is essential to make sure you are getting the best rates you qualify for.