What Is the Difference Between Your Interest Rate and APR? Why Is It Important?

Shopping for a mortgage isn’t something you do regularly and because of that, it can be confusing. There is a way to make comparing your options easier and avoid unpleasant surprises. That’s where annual percentage rate (APR) comes in.

Many people, especially new homebuyers, wonder if interest rate and APR are the same thing. The quick answer is no. Let’s examine their differences and share why each is important in the homebuying process.

APR vs. interest rate

Both terms are expressed as annual percentages, so how are they different? To understand the difference between interest rate and APR, let’s start by looking at each term individually.

What is interest rate?

In the mortgage world, interest is what you pay to borrow money from a lender. Your interest rate is an annual percentage of your balance that determines how much you will pay to borrow that money. It’s typically the most common rate advertised by mortgage lenders.

What is APR?

APR stands for annual percentage rate. It takes a more holistic view of a loan, taking into account interest plus some of the fees associated with the loan. That’s why you’ll usually find a loan’s APR to be higher than its interest rate.

APR generally includes costs such as:

• Interest
• Origination fees
• Discount points
• Mortgage insurance

Why does the interest rate and APR difference matter?

Shopping for a mortgage often starts by comparing interest rates, but it shouldn’t end there. Interest rates only tell part of the story. A mortgage comes with additional fees that can affect your monthly payment and how much you pay for the loan overall. The APR allows you to comparison shop more accurately.

APRs aren’t always readily available, but thanks to the Truth in Lending Act, lenders are required to disclose certain loan terms – including APR – to help consumers make financially sound decisions. For this reason, you’ll always be provided the APR on a loan estimate before you sign off. If you want to know the APR before getting an official estimate, you have every right to ask your lender for this information.

Interest rate vs APR mortgage example

Let’s say you’re trying to decide between two mortgages offered by different lenders. Lender A offers you an interest rate of 5.75 percent while Lender B offers 5.5 percent with the purchase of a discount point, which increases your closing costs by thousands of dollars. You also find out Lender B has higher origination fees. How do you know which option is better?

The answer is not immediately clear, so you use an amortization calculator and lay out the offers side by side.

Finally, you can see how paying the higher upfront fees with Lender B helps you save on both your monthly payment and in the total amount paid for the loan — including closing costs.

While this is a worthwhile exercise, it can be time consuming and isn’t always feasible when you’re trying to narrow down a potential list of multiple lenders. Enter: APR.

At a quick glance, you can see Lender B’s APR is lower. Its APR is 0.298 percent higher than its interest rate, showing there are additional fees tucked into the loan. In contrast, Lender A’s APR is only 0.121 percent higher than its interest rate. You can safely assume the closing costs are lower.

Is the loan with the lowest APR always the right choice?

Not necessarily. Like so many financial decisions, the answer is not black or white. In our example, you may have assumed you should choose Lender B because the loan would cost less. But there are times when Lender A may make sense.

Take, for instance, if you’re planning on selling your home in the next few years. You may not want to pay all those upfront costs when you won’t be in the house long enough to make the expense worthwhile. You may accept a slightly higher monthly payment, knowing you saved on closing costs.

Lender B also wouldn’t make sense if you don’t have enough cash available for the higher closing costs or you know you are going to need the funds for something else in the near future.

A final look: What’s the difference between interest rate and APR?

To wrap up this comparison, let’s look at some high-level similarities and differences between rate and APR.