Mortgage Rate vs APR
Understanding the Difference: Mortgage Rate vs. APR Explained
When you apply for a mortgage loan, the lender will provide you with an early disclosure called a loan estimate. You can use the loan estimate to compare offers from several different banks or mortgage lenders. The loan estimates will disclose several essential items that will show you how much you need to pay to borrow money.
When comparing loan estimates, you should look at the mortgage interest rate and the annual percentage rate (APR). Both figures are expressed in percentages, so it’s easy to confuse them at first glance. However, understanding the critical differences between the two will help you see which home loan will give you better value.
This article will explain what makes a mortgage interest rate different from the APR. We’ll also give you some house buyer tips on comparing loan estimates.
What to Know About Mortgage Interest Rates and Annual Percentage Rates
Interest rate is the cost of borrowing money, typically expressed as a percentage of the principal. The annual percentage rate (APR) is the actual cost of borrowing money, including interest and other fees. APR is always higher than the interest rate because it takes into account all of the costs associated with borrowing money, such as origination fees and closing costs.
When comparing loan offers, it is important to look at the APR, not just the interest rate. This will give you a more accurate picture of the true cost of borrowing money. It is important to understand the difference between interest rates and APR so that you can make informed decisions when borrowing money.
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Definition of Mortgage Interest Rate
Every mortgage has two parts: the principal and the mortgage interest rate. The principal is the money you originally borrowed/agreed to pay back, while the mortgage interest rate reflects the cost of borrowing that principal.
Let’s say you borrowed $300,000 at a 5% interest rate. The annual interest expense would be $15,000. You’ll be paying interest expenses yearly on top of paying off the principal. This is how lenders earn money from offering mortgages.
Your principal balance is high at the beginning of your loan, so you usually pay more toward interest. As you pay off the principal through your monthly payments, you owe less interest and pay a more significant percentage towards the principal. This is called mortgage amortization.
How Are Interest Rates Calculated?
Mortgage rates are determined by numerous factors, such as:
- Your credit score: If you have a good score, lenders will see you as a low-risk borrower and offer you a lower interest rate. Meanwhile, if you have poor credit, lenders will see you as a high-risk borrower and offer you a higher rate.
- The loan term period: Lenders prefer you pay off loans as quickly as possible. You get a lower interest rate if you choose a short-term (5 to 15 years) than a long-term (20 to 30 years) repayment schedule.
- The loan amount: It’s risky for lenders to lend a large amount of money. So, if you’re taking out a jumbo loan, you may have a higher interest rate.
Aside from these, the federal funds rate may also influence a loan’s interest rates. This refers to the rate at which commercial banks borrow and lend excess money to one another overnight. The US Federal Reserve (the Fed) sets it up eight times a year.
During an economic recession, the Fed may lower the federal funds rate to encourage people to spend money. For instance, it was reduced to near zero to help the economy recover from the COVID-19 pandemic. On the other hand, the Fed may also raise interest rates during solid growth to encourage people to save money.
From a borrower’s standpoint, it’s best to take out a loan during periods with low rates to pay less interest on your mortgage. When applying for a mortgage loan, you can also try to take advantage of locking in your interest rate with your mortgage lender. This will prevent the lender from increasing your interest rate until the mortgage loan closes or the lock period expires, whichever comes first.
Definition of Annual Percentage Rate (APR)
The Federal Truth in Lending Act mandates that every consumer loan agreement should provide the APR. This rate reflects the mortgage interest rate and any other charges that are considered to be finance charges that you pay to get the loan. These charges may include the following:
- Loan origination fees
- Mortgage broker fees
- Application fees
- Discount points
- Mortgage insurance, if required
Since the APR reflects the interest assessed on the mortgage loan and certain additional charges, it is higher than the interest rate. Consider the effective interest rate you’ll pay once you close the mortgage loan.
Remember that some fees, such as appraisal and inspection, might not be included in the APR. Ask your lender what is and isn’t included in the APR when comparing offers.
How Are APRs Calculated?
The APR is calculated by adding the total fees with the original loan amount, applying the interest rate, and then dividing the figure by the actual loan amount.
For example, let’s say you agreed to borrow $200,000, and you need to pay finance charge fees that amount to $6,000. With a total loan amount of $206,000 and an interest rate of 5%, you must pay $10,300 annually. Finally, divide $10,300 by the original loan amount of $200,000. This leaves you with an APR of 5.15% versus a mortgage interest rate of 5%.
When comparing loans, the rule of thumb is to emphasize the APR. Sometimes, these closing costs can add up, leaving you with a costly mortgage. Additionally, some lenders may charge low interest rates but high lender fees, which will be reflected in the APR when you compare loans from different lenders.
Historical Trends in Mortgage Rate and APR
Mortgage rates and APRs have fluctuated over time, but they have generally trended downward. For instance, the average 30-year fixed-rate mortgage rate was 18.4 percent in 1981, but it has since fallen to around 6 percent. There are a number of factors that can affect mortgage rates and APRs, including:
- The Federal Reserve’s interest rate policy
- The level of inflation
- The state of the economy
- The supply and demand for mortgages
It is important to keep an eye on historical trends in mortgage rates and APRs when you are planning to buy a home. By understanding how these rates have fluctuated in the past, you can make more informed decisions about when to buy a home and what type of mortgage to get.
Tips On Comparing Mortgages
It is not always easy to see which home loan is the most affordable, but it is still possible. Here are a few homebuyer tips on how you can compare your mortgage options:
Don’t Compare Apples With Oranges
To compare mortgage loan estimates effectively, you should compare loans with the same features. To accurately compare, the loan estimates should be similar in the following categories:
- Loan Type
- Rate type (fixed vs. adjustable)
- Loan term
- Down payment amount
- Points/credits
- Rate lock period, if locked
For example, if looking at the APR rate from one lender, do not compare it with the mortgage interest rate from another. Similarly, do not compare the APR of a 15-year loan with the APR of a 30-year loan.
Getting Loan Estimates Within A Short Window
Mortgage rates are subject to change daily. Make sure your Loan Estimates are within a close period. This ensures that you’re using updated numbers when comparing loan estimates.
The Consumer Financial Protection Bureau also recommends comparing loan estimates within a 45-day window. Doing this will have less impact on your credit score based on credit inquiries from different lenders.
Understand Fixed-Rate vs. Adjustable-Rate Mortgages (ARM)
Fixed-rate mortgages have a consistent/fixed interest rate throughout the life of the loan. Meanwhile, adjustable-rate mortgages have interest rates that can change after a predetermined period. Because of the ARM’s unpredictability, the provided APR will not 100 percent accurately reflect what you’ll pay for your mortgage loan over the term of the loan.
Final Thoughts
The mortgage interest rate shows you the cost of borrowing money to buy a property. Meanwhile, the APR reflects this interest rate plus other fees associated with taking out a mortgage. Because of this, APRs give you a more accurate picture of how much you’ll have to pay for the mortgage loan.
If you want more advice or information on comparing mortgage loans, contact Wesley Mortgage! Our experienced and helpful team can help consumers determine which mortgage loan is right for them.