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This question comes up a lot in Zillow Advice, so this post will help explain the difference between interest rate and APR (Annual Percentage Rate).  Basically, think of the interest rate as the starting point in what you will pay for a mortgage loan and then, tack on associated fees to calculate the APR.

Let’s begin with some definitions:

What is the interest rate?
The interest rate is the percentage of the loan amount that is charged for borrowing money.   We can consider this the base fee.  It is very important when comparing loan quotes since it directly affects monthly payments.

What is the APR (Annual Percentage Rate)?
The APR is a calculated rate that not only includes the interest rate but also takes into account other lender fees required to finance the loan.  The idea behind APR is to help consumers understand the tradeoffs between interest rate and the fees paid at closing (such as paying higher fees to lower interest rates or increasing interest rates to cover closing costs).  The government thought this was important so they required it to be shown next to the interest rate as part of the Truth in Lending Act.

Here is a diagram showing how APR tries to balance interest rate and fees:

How APR is calculated

Conceptually:
To calculate the APR, the lender fees (fees required to finance the loan) are incorporated into the interest rate.  This is done by amortizing the fees out over the life of the loan as if they were additional payments, and then calculating a new rate.

Specifically: (feel free to skip this paragraph)
The fees are added to the original loan amount ($200,000 + $3,000) to create a new loan amount ($203,000).  This new loan amount, along with the interest rate (5.00%), is used to calculate a new monthly payment ($1089.75).  The APR is then calculated by working backwards to figure out what the rate would have to be for a loan with the new monthly payment ($1089.75) and the original loan amount ($200,000).  This is your APR (5.13%).  The APR is typically higher than the interest rate because it includes the fees.

Limitations of APR
As useful as the APR can be, it has its limitations.  APR spreads the fees paid upfront over the life of the loan.  So the comparison of APR is only accurate if you plan to keep the mortgage for the entire length of the loan.  Since most borrowers do not keep their loan for the full period (they typically refinance or move), the APR can make some loans look artificially better.  In the example above, if you only kept the loan for 3 years, the second loan would be much more expensive even though it has a lower APR.  This is because the $6,000 in fees is paid upfront whereas the higher interest rate in the first loan is amortized over the life of the loan.  See my post on whether or not you should pay points to learn more about the tradeoffs of paying interest upfront versus over the life of the loan.

The other problem with APR calculations is that different lenders may include different fees in their APR calculations for various loan programs.  Remember to always ask your lender what is included and not included in your APR.

  • http://www.MortgageRatesReport.com Brian Brady

    “So the comparison of APR is only accurate if you plan to keep the mortgage for the entire length of the loan. Since most borrowers do not keep their loan for the full period (they typically refinance or move), the APR can make some loans look artificially better.”

    BINGO!

    This might be one of the first times I’ve heard a non-industry author articulate this glaring limitation correctly. Consumers would do well to “accept and sign” the government-mandated disclosure but demand additional TILA disclosures, computed to the expected hold time, for a more accurate analysis.

  • http://www.zillow.com/profile/justinmchood Justin McHood

    Nate, way to flex your mortgage muscles! This is an excellent, clear-cut, easy-to-understand guide to APR.

    I am just going to print this out (along with Brian’s comment) and hand it to people when they ask me about this topic.

    Justin

  • Kiran

    When is it the case that the advertised rate is higher than the advertised APR?

    What about 5/1 or other ARM loans? Does the advertised APR reflect expected changes in the underlying index over the next 30 years?

  • http://www.zillow.com/profile/Nate Nate Moch

    Kiran,
    Good question. Yes, the advertised rate can be higher than the APR. This can happen on ARM loans when index rates are low (you can see this in the current marketplace).

    For ARM loans, APR is calculated using different rates. The stated interest rate is used for the locked period of the ARM. For a 5/1 ARM this would be 5 years. However, for the remaining 25 years, the calculation uses the current value of the underlying index plus the margin. When the index rate is extremely low, the readjustment can bring down the APR below the initial rate.

    Unfortunately, the APR calculation does not reflect expected changes in the underlying index over the life of the loan. It assumes that the index stays the same (which we know will not be the case!). This is another big limitation of the APR calculation for adjustable rate mortgages.

    Hope that helps,
    Nate

  • Kiran

    Thanks for your explanation!

  • sam

    Nate,

    Can you confirm this?

    1. If you are planning to stay for the full length of loan period in the house and if if I am looking for fixed rate loans.. I should pay attention to APR.

    2. If I am looking for the 7/1 arm as I am not sure if i will stay for long in my current, I should pay attention to the interest rate

    3. If I am comparing the total monthly cost between fixed and arm, I should compare the interest rate and not the APR. I understand that I will have to account for the fees and closing costs seperately.

  • http://preventaging.blogspot.com/ Ramala Jones

    Some helpful tips of avoiding paying more interest is to put money down which would lower that 100,000, also to pay extra on your mortgage which lowers the principal amount and basically you are calculating interest on a lower amount which means a lower amount of interest would add up. Another thing that could save you a lot of money on your mortgage in interest is to make your payment more frequently. For example if you pay 1000 a month on your mortgage, pay 500 every two weeks which equals the same amount of money you are paying monthly, but this lowers the amount of interest because you pay interest on interest so the more frequent your payment the lower your principal balance and the lower the daily amount of interest will be.

  • http://www.tamirgroup.com Loan Modification

    Thanks for sharing this info post with us.

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  • Long Duan

    Quote: “The fees are added to the original loan amount ($200,000 + $3,000) to create a new loan amount ($203,000). This new loan amount, along with the interest rate (5.00%), is used to calculate a new monthly payment ($1089.75). The APR is then calculated by working backwards to figure out what the rate would have to be for a loan with the new monthly payment ($1089.75) and the original loan amount ($200,000).”

    I don’t quite understand this part. It seems that the $3,000 fee is also generating interests that has to be paid by the consumer. However, isn’t that customer paid the $3,000 fee at the closing (i.e., as a part of the closing cost)? If yes, they why does the customer has to pay the interests for that for the next 30 years?

  • A.

    Thank you for a great article – it made me realize that there are two completely different types of fees associated with a mortgage loan: the closing charges (not included in APR), and the servicing costs (included in the APR) – silly me thought the servicing costs would be taken out of all that interest that a lender is earning on my loan!

  • Robert

    Okay, I’m totally confused. I’m trying to apply for a credit card to improve my credit score but was confused. Is it better to get a higher APR or a lower? Does it even matter? How about interest? Please explain this as easiest as possible. I don’t get why the fee is $3,000 when the apr is 5.13% when the 5.11% is at $6,000. So the lower the APR, the higher you pay?

  • Dave

    Nate,

    Thanks for the article…I understand that the mortgaged loan closing costs are rolled into the mortgage thus increasing the actual interest rate.

    My question is: do the fees associated with closing a mortgage have to be rolled in the mortgage. If I borrow $250K and the mortgage company wants to charge be a $1500 fee, I’d rather pay it up front than roll it into the mortgage.Is this an option?

  • http://www.zillow.com/mortgage Nate Moch

    Dave,
    Good question. No, the fees do not have to be rolled into the mortgage. Closing costs can definitely be paid up front at closing. I would recommend doing this if you have the money since it will save you from paying interest on the fees.
    Nate

  • http://www.zillow.com/mortgage Nate Moch

    Robert,
    The APR is a combination of both the rate and fees. This means that you can’t compare APRs just by looking at fees.

    However, if the interest rates for two loans are the same, the one with the higher fees will also have the higher APR.
    Nate

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  • george see

    i just bought a home that advertised no interest,but an apr of 6.25% im confused,i thought they were the same

  • http://www.zillow.com/mortgage Nate Moch

    George,
    I am not sure what to tell you since I don’t know what was being advertised, but perhaps they were trying to say the loan will not incur interest for a short initial time period. Or perhaps there is a large 6.25% upfront fee (e.g., you buy enough points on the loan upfront to reduce the interest rate to 0%). I would be leery of any mortgage saying no interest.

    It is common for stores to advertise “no payments” or 0% interest for X months. However, once the initial period is over, the interest rates are typically pretty steep. They use these financing programs to get more people to buy their products. This is not something you see with mortgages though.

  • Jerry Sell

    If I’m not mistaken, an origination fee (1% of the loan amount) does NOT have to be include in the APR. While a point (1% of the loan amount) is included in the APR, an origination fee is not. Given your example of a $200,000 loan amount, 1% equals $2,000.

    Example: One lender quotes the APR including a point, while a second lender quotes a LOWER APR simply because he does NOT quote a point. (The second lender is charging an origination fee which does NOT have to be include in the APR.)

    The consumer, not being privy of the the above info, selects the lender offering the lower APR. However, the consumer pays as much (if not more) in fees as a result of the incomplete and confusing disclosure method.

    The mortgage industry has seen many changes the past 18 months. As basic and blatant as this simple change would provide for better consumer disclosure, the government bureaucrats have failed the populous once again. The change is SO obvious, one has to wonder if the government is truly trying to help the consumer understand mortgage lending!

  • http://www.zillow.com/mortgage Nate Moch

    Jerry,
    Both origination and discount points should be included in the APR calculation. The origination point is a fee the lender charges to originate the loan. The discount point is a fee you pay upfront to lower the interest rate. Both of these fees should be included.

    Note that the APR can go down when you buy points. This is not because the point is not included in the APR. It is because the rate drops when you pay the point. So if you have the loan for the full term, you may more than make up for the point you paid over the life of the loan. However, as I pointed out in the limitations section, the APR assumes you have the loan for the full term. If you only keep the loan for 5 years, it may actually be more expensive to buy the point. See my article on paying points for more info: http://www.zillow.com/blog/mortgage/2009/04/27/should-i-pay-points-on-my-home-loan/
    Hope that helps,
    Nate

  • http://Explorer Diana Lane

    If all the closing costs and pre-paids are payed at closing with a loan that is not charging points, what is left to account for the APR still being higher than the note rate?
    Thank you,
    Diana

  • http://www.zillow.com/mortgage Nate Moch

    Diana,
    The APR includes fees required to finance the loan. The fees are included in the APR calculation whether they are paid at closing or rolled into the loan.

    Here are some typical fees that are included in the APR calculation:
    * Loan origination fee
    * Loan discount (or points)
    * Loan processing fee
    * Underwriting fee
    * Broker/application fees
    * Mortgage insurance premiums

  • http://Explorer Diana Lane

    O.k.

    So if you have none of these things in your loan, let us say they are paid outside od closing. How do you still have a higher APR?

    Thank you,
    Diana Lane

  • Chhay

    Hi Nate,

    I just bought a house a year ago and the interest rate I locked-in is 5.385. My question is when do I know when to refinance, or should I even consider refinance since it’s only been a year? I paid all fees (loan origination) at closing cost.

  • http://www.traditionalrugrepair.com tezgah

    This is very helpful. My lender tried to explain something different to me. Thank you. Thank you.

  • New home buyer

    Nate, and et al,

    Thank you for the article and the posts. I’ve seen this asked without direct answers: “If the fees (orig fee and all points) are paid at closing, why would these fees also be included in the APR (thereby raising the APR)?

    Second question, Is it a correct assesment to think 0.2% higher on APR is is fair? If not, at what point (any rule of thumb) should the APR raise red flags of concern that the customer is being “snowed.”

    Thank you.

  • Justin

    I have the same question as Diana Lane.

    If you pay all of your closing costs upfront at closing. Are than any fees left over that goes into the APR? Its my understanding that if you pay your closing costs at closing then the interest rate is truly just the interest rate?

    Im asking because I can get the seller to pay closing so I dont care that closing fees are 1000 more making the apr higher, I want lower monthly payment because the interest rate is lower.

  • http://www.zillow.com/mortgage-rates/ Nate Moch

    Justin,
    The APR is meant to show you the cost of the loan which includes the interest rate and the fees. The APR will take into account the fees whether they are paid at close, rolled into the loan, or paid by seller.

    However, if you don’t care about these fees because you know they will be paid by the seller (up to a certain point), then you can just focus on the lower interest rate which will result in a lower monthly payment. It sounds like you don’t really care about the APR because you are not paying the fees.

  • http://www.zillow.com/mortgage-rates/ Nate Moch

    New home buyer,
    Yes, if the fees are paid at closing, they are still included in the APR. The APR is just a calculation to help you compare the total cost of loans upfront (meaning the rate and the fees required to finance the loan). The APR is not the actual interest rate you will pay every year, it is just a calculation to help you make a better decision between different rate and fee combinations. If you pay all of your fees at closing, the rate you will be paying each year on the loan is just the interest rate. However, the APR for the total cost of the loan still includes the fees.

  • http://www.zillow.com/mortgage-rates/ Nate Moch

    Chhay,
    The answer to “when should I refinance” is usually “it depends.” What you should consider when making the decision is how much have rates dropped since you financed your loan, and how long are you planning on staying in your home.

    You want to make sure rates drop enough to cover the costs of refinancing. The amount the rate needs to drop varies based on your loan size and the amount of time you plan to spend in your home. You save more money with a lower rate the longer you have the loan. This means it typically doesn’t make sense to refinance if you are planning on moving in a couple years as it is hard to recoup the costs of refinancing in such a short time. The exception is if the rate is so low you can cover your closing costs and still get a lower rate.

    I would recommend using this free refinance calculator to see if refinancing makes sense for you: http://www.zillow.com/mortgage/calculator/Should-I-refinance-my-home-mortgage.htm

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