Interest Rate vs APR: How Do They Differ?

If you’re in the market for a mortgage, you’ve probably seen that several lending companies tout their lowest Interest Rate vs. APR. Lenders must provide you with both the interest rate and the annual percentage rate (APR) so you may compare the two and make an informed decision.

Borrowers can use the APR to determine if a lender is offsetting a low quoted interest rate with excessive costs. Here’s a tip, you’ll know that the lender’s fees are reasonable if the APR is near the interest rate.

You may believe you have a firm grasp on the concept of annual percentage rate (APR) from dealing with credit cards and vehicle loans, but there is likely much more to the APR structure of a mortgage loan that you are unaware of.

Here, we’ll break down the difference between the Interest Rate vs. APR used by mortgage lenders, and show you how you can utilize this knowledge to lower your monthly payments and pay off your loan faster. 

What Is Interest Rate?

Interest rate refers to the percentage rate at which a debtor must pay back a loaned sum of money over a given time period. In the case of a fixed-rate mortgage, the interest rate will not change during the life of the loan. It’s also possible that the interest rate attached to your mortgage will fluctuate with market conditions.

Your interest rate will always be displayed as a percentage. You must repay the loan principal as well as any interest that has accrued during the loan’s life.

Here’s a case in point to think about. Let’s pretend you borrow $200,000 at 4% interest in order to purchase a home. Your mortgage interest will accrue at a rate of 4% per year, starting from the loan’s origination date. A yearly salary of $8,000 works out to $666 per month.

If you start off with a large principal sum, you’ll end up paying more in interest. However, your interest payments will decrease and more of your payment will be applied to your principal as you make payments over time. This is known as mortgage amortization.

How Are Interest Rates Calculated?

Perhaps you’ve wondered, “What factors into the calculation of interest rates?” Lenders use your specific information to determine your rate of interest. Interest rates are calculated differently by each financial institution.

In the lending industry, you can shop around and find ten lenders offering ten different rates. When determining your interest rate, lenders consider a number of criteria, including the general health of the economy and the current market.

There are a few strategies to negotiate a reduced interest rate with your loan servicer. Your interest rate will likely go down if you take any steps that make borrowing money from you less risky for your lender.

A credit score consists of a three-digit figure that lenders use to quickly and easily assess a debtor’s creditworthiness. High credit scores indicate reliable payment behavior and a tendency to avoid taking on more debt than can reasonably be repaid.

Potential lenders will consider you a higher risk if your credit score is low. If your credit score is low because of past late payments, the lender may compensate for the increased risk by charging you a higher interest rate.

If you want a better credit score, try these strategies:

• Keep up with even the bare minimum payments on loans and credit cards.
• Keep your credit card debt to a minimum.
• Eliminate as much debt as you can.
• While you’re saving up for a loan, don’t apply for any new loans.

What is the Annual Percentage Rate (APR)?

The cost of borrowing money, represented as a percentage of the loan principal each year, is known as the Annual Percentage Rate (APR). Everything from the interest rate to the origination fee to the closing cost to the points is factored in. The Annual Percentage Rate (APR) is a metric used to assess the overall cost of borrowing across various loan options.

Borrowing $1,000 at ten percent interest plus $200 in fees will cost you more in annual percentage rate (APR) than borrowing $1,000 at the same interest rate with no expenses. This is so because the APR shows how much money you will spend on interest and fees combined.

When you factor in the additional costs, the annual percentage rate (APR) is larger than the interest rate. When looking for a loan, comparing annual percentage rates (APRs) is a good way to get a better idea of the entire cost of borrowing.

How Are APRs Calculated?

The interest rate, loan term, and any other fees or charges are all factors in determining the annual percentage rate (APR) for a loan. To explain how it functions:

The total cost of the loan is calculated by adding the origination fee, the closing cost, and any points that were agreed upon between the debtor and the lender. After then, the interest rate is added to the sum by the lender.

Finally, the lender calculates a percentage rate by dividing the entire interest paid on the loan by the principal borrowed. That rate is the annual percentage rate.

To illustrate, suppose you borrow $20,000 at 10% interest plus $500 in fees. This loan would cost a total of $20,300 ($20,000 principal plus $500). 

The annual percentage rate (APR) is the cost of borrowing money expressed as a percentage, and it is calculated by dividing the entire cost of the loan (in this case, $20,500) by the principal loan amount ($20,000) and multiplying by 100. The interest rate is calculated as follows: 10.25% ($20,500 divided by $20,000 = 1.025 multiplied by 100 = 102.5).

The annual percentage rate (APR) is a standardized method of calculating the cost of borrowing money and is therefore helpful for making comparisons between various loan options. But it doesn’t factor in the loan’s specifics, including how long it is or when payments are due.

When evaluating loans, it is important to take these into account because they might have an impact on the overall cost.

Interest Rate vs. APR: Key Differences

Although both the interest rate and annual percentage rate (APR) are used to determine the expense of a loan, they are computed and used in different ways. Some important distinctions between the two are as follows:

Calculation: The interest rate is determined by taking the cost of borrowing money and expressing it as a percentage of the loan’s principal. In contrast, the annual percentage rate takes into account not only the interest rate but also any fees or charges that may be applicable to the loan.

Comparative analysis: When evaluating loans with similar terms, the interest rate is typically employed (e.g., same loan amount, same repayment period). An annual percentage rate (APR) is preferable to other terms when comparing the overall cost of several loans.

Regulation: The lender normally determines the interest rate, which may change depending on the state of the market and the creditworthiness of the debtor. Lenders are required by law to share the APR with debtors. This guarantees that debtors have access to the data necessary to evaluate the overall cost of various loan options.

Is It Better to Have a Lower Interest Rate or a Lower APR?

Which option is better for you depends on how much you care about the monthly payment and how much you care about the total cost of the loan. If the regular payment is more important than the total cost of the loan, then look at the interest rate; otherwise, look at the annual percentage rate (APR).

Paying less each month for interest is possible when rates are reduced. However, that may result in a higher interest rate and a more expensive loan altogether.

One of the most crucial considerations is the interest rate, especially with mortgage loans; if you intend to stay in the house for the next 30 years. It’s possible that you’d be prepared to pay points to get a lower interest rate, even though doing so would increase your annual percentage rate.

On the other hand, if you plan to sell the house in a few years, it might make more financial sense to go with the lower APR.