What’s the difference between interest rate and APR?

The interest rate is the amount a lender charges you for a loan, expressed as a percentage of the total loan amount. APR (annual percentage rate) expresses how much you’re paying in total for your borrowing, including interest payments, upfront costs, and continuing loan costs spread over the life of the loan.

While it might seem like an inconsequential distinction, knowing the difference between interest rate and APR can help you make smarter borrowing decisions and save you a ton of money over the loan term — and over your lifetime. And the same principles apply whenever you’re borrowing money.

APR is generally the better guide to the actual cost of any loan. Read on to discover why — and the important exceptions to that rule.

How to use APR to comparison shop

The higher the APR, the more fees are required to get the loan. To comparison shop, ask the mortgage lender to quote you a certain rate. See if the loan’s APR is higher or lower than on other quotes.

For instance:

Loan #1: 3.0% rate, 3.12% APR
Loan #2: 3.0% rate, 3.05% APR

You can see instantly that Loan #2 has fewer closing costs, as long as both these loans are the same type.

But what about when the rate is different? Example:

Loan #1: 3.0% rate, 3.05% APR
Loan #2: 2.75% rate, 3.10% APR

Loan #2 is actually more expensive overall. It likely has large upfront costs. But if having the lowest possible monthly payment is your priority, you may still consider this loan.

What is a mortgage interest rate?

Interest is the payment you give a lender for allowing you to use their money for a while. You are offered an interest rate when you borrow. Most home loans in America have fixed rates (they’re fixed-rate mortgages or FRMs) so you can be sure your first and last payments — along with all the ones in between — will be the same.

Principal and Interest

Suppose you’re offered a $200,000 FRM with an interest rate of 3%. You’ll pay $6,000 a year in interest ($200,000 x 3% = $6,000). That’s $500 a month.

But, with most loans, you also have to pay down the amount you borrowed (the “principal,” in industry jargon) as you go along. That way, you zero your mortgage balance at the end of the loan’s term — after, say, 30 years. If you were to pay just the interest, you’d still owe $200,000 (the sum you originally borrowed) when your mortgage comes to an end.

So your starting monthly payment for principal and interest may be $843: $500 for interest and $343 toward reducing your mortgage balance. Gradually, as your mortgage balance falls as a result of your continuing payments, you pay less in interest and more toward further reducing your loan balance each month. These changes are part of a process called “amortization.”

If you want to see this in action, use The Mortgage Reports mortgage calculator. Input the numbers that might apply to you, click “View Full Report” and see that scenario in all its high-definition detail. The graph on the page that opens shows how amortization works in the clearest possible way.

Of course, your principal and interest payments aren’t your only homeownership costs. The mortgage calculator also helps you budget for property taxes, homeowners insurance, and homeowners association dues, if applicable. And you need to allow more for maintenance and repairs.

Your Interest Rate and Your Creditworthiness

Not every dollar you pay in interest goes to the lender as profit. Some of what you pay in interest is used to offset losses when other borrowers default, die, move, or otherwise prevent the lender from making the expected return on the loan. Even serial refinancers can cause lenders to take on losses.

To minimize the risk you pose to those returns, lenders will penalize you with a higher interest rate if you’re a big lending risk. But they’ll reward you with a low rate if you’re a safe bet.

With smaller loans, your credit score and report are often enough for lenders. If you want a credit card, modest personal loan, or store card, that score may be all that determines your interest rate.

But for mortgages and refinances, lenders look mostly at three aspects of your financial situation when deciding your interest rate. And those are your:

1. Credit score and report. Your past ability to manage debt well is the best predictor of your future ability to do so.
2. Down payment (loan-to-value ratio or LTV). The bigger your down payment, the lower your likely rate. Because the lender is less likely to lose anything if your loan goes bad.
3. Existing debts (debt-to-income ratio or DTI). The less you owe, the lower your rate. Because you’ve plenty of room to maneuver financially if times suddenly get tough.

If you’re an exceptionally strong borrower across all three of those, you’ll probably have “top-tier” status. And that means you’ll be in line for the lowest possible interest rates.

What is an APR?

You could think of APR as your mortgage rate’s less sexy, highly educated, but boring older brother.

APR expresses the total cost of your borrowing. It builds in the upfront and continuing costs associated with the loan and spreads them evenly over the monthly payments throughout the loan’s term, and adds them to your base interest rate.

And with mortgages, which sometimes have high closing costs and perhaps mortgage insurance, this is important.

That means that one of the most important differences between interest rate and APR is that the latter is usually a better indicator of the actual cost of a loan.

APRs in action

If you look at current interest rates, you’ll see they are generally expressed both as an interest rate and an APR.

For example, at the time of this writing, rates are as follows: 30-year FHA loan:

• 2.25% interest rate; 3.226% APR
• 30-year VA loan: 2.25% interest rate; 2.421% APR

So why the big difference in APRs for two loans with the same interest rate?

Well, VA loans (available almost exclusively to veterans and those serving in the armed forces) charge most borrowers a VA funding fee, which makes closing costs high. But that buys out those borrowers from ever having to pay mortgage insurance premiums. So continuing costs means are low which means a lower APR.

However, FHA loans (available to most buyers, including those with only fair credit) require borrowers with less than a 20% initial down payment to pay continuing mortgage insurance every month. And, plus closing costs, that results in a higher APR.

So you can see how useful the APR can be. Two loans with the same interest rate can actually cost very different amounts and have very different mortgage payments.

When to treat the APR with caution

But APR works a little differently depending on the term of the loan. The cost element of an APR is spread evenly over all the months within a mortgage loan’s term — most commonly 30 years. Suppose you move or refinance after seven years, which many homeowners do.

The APR spreads your upfront fees and continuing costs evenly over the 360 monthly payments that a 30-year FRM requires (30 years x 12 months = 360 payments). But you’re going to make fewer payments: 84, if you move after seven years (7 x 12 = 84). Fewer yet, if you sell or refinance sooner.

There are few circumstances under which you should regard APR with caution. These include when you’re:

1. Planning to move or refinance in seven years or earlier.
2. Comparing the cost of a cash-out refinancing with that of a home equity loan or home equity line of credit (any second mortgage).
3. Shopping for a home equity line of credit (HELOC). Fees aren’t included in APRs for these.
4. Looking at adjustable-rate mortgages. The APR won’t show the maximum interest rate of the loan.

Of course, none of this means you should ignore APR either. Instead, you need to investigate and weigh costs separately, so you understand how they apply to you.

APRs are comparable

All lenders are obliged by the Truth in Lending Act (TILA) to calculate their APRs using the same formula. So you can safely compare them when looking at similar loans.

But they’re dangerous if you try to compare loans with different terms. So you shouldn’t, for example, use APR to compare a fixed-rate mortgage to an adjustable-rate one, or a primary mortgage to a secondary mortgage.

Your loan estimate is often a better source than your APR

Your candidate lenders must, by law, send you a standardized loan estimate when you’re finding a new mortgage or refinancing. You should get one in response to each of the applications to multiple lenders that any smart borrower makes.

Check page 3 of each of the ones you receive. Here’s an example of what you should see, copied from the CFPB’s website:

The “In 5 years” bit is useful when you’re comparing loan estimates and they’re especially helpful when you think you’re likely to move or refinance in five to seven years. And you should take those figures at least as seriously as your APR.

Not all closing costs are included in your APR

It’s important to note all closing costs are included in the calculation of your APR. Lots of the most variable closing costs are included: origination fees, discount points, and mortgage insurance upfront premiums.

But some are excluded such as title costs, appraisal fees, local taxes, credit report fees, attorney and notary fees.

But, given that all lenders should calculate annual percentage rates in the same way, that still leaves APRs useful and comparable.

APR vs. Interest Rate: Finding the Best Deal

Both interest rate and APR are important tools to help you find the best mortgage to suit your personal finances and determine what the true cost of your loan will be.