When you’re shopping for a loan, don’t let your research end with a comparison of lenders’ interest rates. While a low interest rate is appealing, it’s important to also look at each loan’s annual percentage rate (APR), which will provide a clearer picture of how much the loan will cost you when fees and other costs are factored in.
APR vs Interest Rate: Understanding the differences
The difference between APR and interest rate is that APR will give borrowers a truer picture of how much the loan will cost them. While APR is expressed as an interest rate, it is not related to the monthly payment, which is calculated using only the interest rate. Instead, APR reflects the interest rate along with fees and other one-time costs a borrower will pay for a loan.
“You can find a mortgage that has a 4-percent interest rate, but with a bunch of fees, that APR may be 4.6 or 4.7 percent,” said Todd Nelson, senior vice president-business development officer with online lender Lightstream. “With all of those fees baked in, they are going to swing the interest rate.”
For example, one lender may charge no fees, so the loan’s APR and interest rate are the same. The second lender may charge a 5 percent origination fee, which will increase the APR on that loan.
How the APR is calculated
Lenders calculate APR by adding fees and costs to the loan’s interest rate and creating a new price for the loan. Here’s an example that shows how APR is calculated using LendingTree’s loan calculator.
A lender approves a $100,000 at a 4.5 percent interest rate. The borrower decides to buy one point, a fee paid to the lender in exchange for a reduced rate, for $1,000. The loan also includes $900 in fees.
With these fees and costs added to the loan, the adjusted balance being borrowed is $101,900. The monthly payment is then $516.31 with the 4.5 percent interest rate, compared with $506.69 if the balance had remained at $100,000.
To find the APR, the lender returns to the original loan amount of $100,000 and calculates the interest rate that would create a monthly payment of $516.31. In this example, that APR would be 4.661 percent.
APRs will vary from lender to lender because different lenders charge different fees. Some may offer competitive interest rates but then tack on expensive fees and costs. Lenders with the same interest rate and APR are not charging any fees on that loan, and lenders that offer APR and interest rates that are the closest will charge the least-substantial amount of fees and extra costs.
What can impact my APR?
While APR will change as interest rates fluctuate, lenders’ fees and costs will have the greatest impact on APR. Here are some of the fees that will affect the APR.
Discount points: Buying points to lower a loan’s interest rate can have a significant impact on APR. Lenders allow buyers to purchase “points” in return for a lower interest rate. A point is equal to one percent of the mortgage loan amount. For example, a buyer approved for a $100,000 loan could buy three points, at $1,000 each, to lower the interest rate from 4.5 to 4.15.
Loan origination fees: Loan origination fees typically range between 1 and 6 percent, according to Nelson. This can be especially significant for larger loans.
Loan processing: This fee, which some lenders will negotiate, pays for the cost of processing a mortgage application.
Underwriting: These fees cover an underwriter’s review of a loan application, including the borrower’s income, credit history, assets and liabilities, and property appraisal, to determine whether the lender should approve the loan application and what terms should be applied to the loan.
Appraisal review: Some lenders pay an outside reviewer to make sure an appraisal meets underwriting standards and that the appraiser has submitted an accurate report of the home’s value.
Document drawing: Lenders often charge a fee for creating mortgage documents for a loan.
Commonly not included in APR are notary fees, credit report costs, title insurance and escrow services, the appraisal, home inspection, attorney fees, document preparation and recording fees.
Because APR includes a loan’s interest rate, rising interest rates will increase APR for mortgages, auto loans and other types of loans and credit.
Interest rate vs APR: What should I focus on when shopping for a mortgage?
While lenders often push their low interest rates when they advertise loans, Nelson said it’s vital that consumers check loans’ APR when shopping around and pay attention to how loan advertisements are worded.
“Look for a lender that’s transparent about disclosing all of those fees,” he said. Lenders may advertise “no hidden fees,” he said, but that might mean there are other fees that simply aren’t hidden.
Here’s how two loans for the same amount can have different APRs.
Fees and costs
Fixed interest rate
The Truth in Lending Act requires lenders to disclose APR in advertising so that consumers can make an equivalent comparison between loans. If two loan offers have similar APRs, request a Good Faith Estimate (GFE) or Loan Estimate from each lender.
Lenders are required to provide this document, which shows all expenses associated with the mortgage, within three business days of the loan application date. Some lenders may be willing to supply a loan estimate for consumers who are shopping for a loan.
APRs on Adjustable Rate Mortgages (ARMs): What to know
It’s important to remember that the APR on ARMs will not apply for the life of the loan, as the payment on the loan will change as the economy fluctuates. APR on ARMs is calculated for the interest rate during the loan’s introductory period, and no one can predict how much the rate will increase in years to come.
A loan with a 7/1 ARM, for example, will have a fixed rate for the first seven years that is determined by the current economic conditions on the day the loan was approved. After seven years, the lender will begin to adjust the rate based on movement of the economic index, which likely will not be the same as it was when the loan was approved. Rates fluctuate daily, and no economic forecaster can predict where the index will be in 20 or 25 years.
Understanding mortgage interest rates
A mortgage rate is another term for interest rate, which is the rate that a lender uses to determine how much to charge a customer for borrowing money. Mortgage rates can be either fixed or adjustable.
Fixed mortgage rates do not change over the life of a loan. For example, if you take out a 30-year loan at a 4.25 percent interest rate, that rate will stay the same regardless of changes in the economy and market index, through the entire lifetime of the loan.
Adjustable rate mortgages (ARM), on the other hand, will change as the market changes after an introductory period, often set at five or seven years. That means your interest rate could go up or down depending on economic conditions, which will in turn raise or lower your payments.
ARMs, which are a common type of mortgage loan with an adjustable rate, often start with a lower interest rate than a fixed mortgage — but only for that introductory period. After that, the rate could go up as it adjusts to market conditions, which could raise your payment accordingly.
If you are considering an ARM, it’s important to talk to your lender first about what the adjustable rate could mean for your loan payment after the introductory period. The federal government’s Consumer Financial Protection Bureau (CFPB) recommends researching:
- Whether your ARM has a cap on how high or low your interest rate can go.
- How often your rate will be adjusted.
- How much your monthly payment and interest rate can increase with each adjustment.
- Whether you can still afford the loan if the interest rate and monthly payment reach their maximum under your loan contract.
How is your mortgage rate calculated?
Don’t be surprised if a lender offers you a mortgage interest rate that is higher than what is advertised. Each loan’s interest rate is primarily determined by market conditions and by the borrower’s financial health. Lenders take into account:
- Your credit score: Borrowers with higher credit scores generally receive better interest rates.
- The terms of the loan: The number of months you agree to pay back the loan can make a difference. Generally, a shorter term loan will have a lower rate than a longer term loan but higher monthly payments.
- The location of the property you are purchasing: Interest rates are different in rural and urban areas, and sometimes they can vary by county.
- The amount of the loan: Interest rates can be different for loan amounts that are unusually large or small.
- Down payment: Lenders may offer a lower rate to borrowers who can make a larger down payment, which often is an indicator that the borrower is financially secure and more likely to pay back the loan.
- Type of loan: While many borrowers apply for conventional mortgages, the federal government offers loan programs through the FHA, USDA, and VA that often offer lower interest rates.
How often do mortgage rates change?
Mortgage rates fluctuate on a daily basis. Because the market changes so often, lenders typically give borrowers the opportunity to lock in or float your interest rate for 30, 45, or 60 days from the day your lender approves your loan. That way you won’t get burned if rates rise soon after you secure a loan.
If you choose to lock in your rate, lenders will honor that rate within the agreed-upon time period before closing regardless of market fluctuations. Floating your rate will allow you to secure a lower interest rate before closing, should rates drop during that period.
How do mortgage rate changes impact the cost of borrowing?
Small differences in the interest rate can cost a borrower thousands of dollars over the life of the loan. Here’s an example for a 30-year, fixed-rate mortgage using our parent company LendingTree’s online mortgage calculator tool:
Fixed interest rate
Total borrowing cost
What’s a good rate on a mortgage?
While mortgage rates change daily, Nelson noted that mortgage rates have stayed low for several years now and don’t show signs that they will increase drastically in the nearly future.
LendingTree’s LoanExplorer tool recently showed interest rates for a 30-year, fixed-rate mortgage as low as 3.625% for borrowers with excellent credit.
When shopping for loans, you can best compare loans by getting mortgage quotes from lenders at the same day on the same time. Online marketplaces such as LendingTree also can provide real-time loan offers from multiple lenders, which makes it easier to compare mortgage APR vs. interest rates.
Don’t be dazzled by low interest rates. If the loan’s APR matches its low interest rate, you likely have a good deal. Otherwise, investigate the costs and fees behind a loan’s APR to best determine which loan offer is the best deal.
Learn more about how you can compare quotes from lenders at LendingTree.com.