Difference Between Interest Rate and APR

Interest rate is the the initial cost of borrowing money. Annual percentage rate (APR) reflects the total cost of borrowing money once fees are factored in. You'll often see the terms interest rate and APR when comparing lenders, accessing credit card options, or acquiring financing for an auto loan or mortgage.

When you take out a mortgage to buy or refinance a home, the interest rate is what you agree to pay the lender for loaning you money. The APR is the total cost of the mortgage including any additional fees for approving, processing, and providing the loan.

One benefit of knowing the difference between interest rate and APR is saving money. A slight variation in rates can mean paying more or less over the life of your loan. In this guide, we'll cover more about the differences, how to compare the two rates and how they're calculated.

What is the difference between interest rate and APR?

The interest rate is the base cost to borrow money from a lender, while the annual percentage rate (APR) is the total cost to borrow money. APR includes the base interest rate and fees, such as upfront costs the lender charges for originating the loan and points you purchase to buy down your rate.

Both APR and interest are expressed as a percentage of your principal loan balance (the amount that you're borrowing). APR is the yearly cost of your mortgage, and interest is recalculated each month based on the remaining principal balance.

Why is APR higher than interest rate?

On a mortgages and other types of loans, the APR will almost always be higher than the interest rate because it includes fees. Credit cards are more likely to show the same APR and interest rate, because they often don't include fees in the calculation. Mortgage APR includes your base interest rate in addition to the following applicable fees:

• Mortgage insurance: When you put down less than 20% with a conventional loan or buy a home with an FHA loan, you'll usually be required to pay mortgage insurance. Your premiums are factored into your APR.
• Origination fees: The administrative costs for creating your mortgage loan are included in the APR. This covers a set of fees from preparing documents, processing your application and loan to underwriting services and appraisal and credit report fees.
• Mortgage broker fees: If you worked with a broker to buy your home, any commissions or service chargers that you owe to brokerage will be included in your APR.
• Mortgage discount points: If you choose to buy points to lower your interest rate, you'll pay a fee to your lender. The fee is included in your total APR.

How to compare interest rate vs APR on a mortgage

When comparing mortgage lenders, you’ll want to consider both the interest rate and APR they’re offering. Use the interest rate as a baseline to determine your monthly payments, and use APR to determine your total cost for the loan. APR is often referred to as the actual cost of your mortgage, making it the best way to compare your borrowing costs when choosing a lender. Here's an example of how a lower interest rate compares to a higher APR.

Lender 1 offers you a lower interest rate, but has much higher origination fees and requires you to purchase discount points.

Lender 2 offers a higher interest rate, but with fewer lending fees, and isn’t offering or encouraging discount points.

When we compare Lender 1 and Lender 2 for the same $300,000 fixed-rate mortgage with a 30-year term, Lender 1 is offering a lower interest rate and APR compared to Lender 2. Financing with Lender 1 means you'll pay less interest over the life of the loan (because your APR is lower) and have lower monthly payments (because your interest rate is lower).

In this scenario, Lender 1 is offering a better mortgage option than Lender 2 as long as you can afford paying higher upfront closing costs. While you'll pay more over the 30 years with Lender 2, you'll pay less upfront, which may help you unlock homeownership sooner than later.

How is mortgage APR calculated?

Mortgage APR is calculated annually and divided into monthly payments. Like mortgage interest, APR is expressed as a percentage of the loan amount. However, it accounts for all the costs involved in a mortgage, including interest. 

While your lender will do the math for you, you can estimate your mortgage APR by adding your interest rate and fees associated with the loan, and dividing that number by the sum of your principal balance. The result is then divided by the number of days within your loan term, multiplied by 365, and again by 100 to get a percentage.

Depending on the terms of your loan, your mortgage APR will likely vary monthly or annually if you have an adjustable-rate mortgage (ARM). This is because the APR on an ARM will change to reflect the current interest rate at the time of recalculation. The APR on a fixed-rate mortgage will remain the same throughout the life of the loan.

How is mortgage interest calculated?

Mortgage interest rates are calculated using complex formulas based on current market conditions, lender criteria, inflation, and your individual financial factors. Lenders typically use the federal funds rate set by the U.S. Federal Reserve to establish their prime rate for mortgage interest. The prime rate is a benchmark financial institutions use to determine interest rates for all types of mortgage loans. From there, lenders will look at financial factors you can control to set your interest rate, such as:

• Credit report and score
• Debt-to-income ratio (DTI)
• Loan-to-value ratio (LTV)
• Down payment amount
• Loan type and terms

Viewing your estimated APR is the best way to compare lenders and understand your total cost of borrowing. See what type of rates you may qualify for by pre-qualifying with us at Zillow Home Loans today.*

*An equal housing lender. NMLS #10287