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The interest rate for a loan determines the amount of interest you’ll pay annually after borrowing money. However, a loan’s annual percentage rate (APR) is often more useful for comparing different loan options because the APR includes the cost of fees as well as interest.
When comparing loans—especially for a mortgage—you’ll likely encounter information about both interest rates and annual percentage rates (APR). Understanding both of these terms will help you compare different loans more easily so that you can find the right loan for your situation.
Your credit score will play a role in what mortgage interest rates you’re offered, but you are nonetheless likely to have several options, which can be difficult to compare.
Read on to learn more about the difference between interest rate and APR as well as how to compare mortgage loan costs.
What is the difference between interest rate and APR?
While the interest rate will give you a sense of how much you’ll owe each year for borrowing money with a loan, the annual percentage rate (APR) gives a more complete picture of borrowing costs since it includes fees associated with the loan.
A quick comparison of interest rate and APR helps illustrate the differences between these two numbers.
Interest rate
The interest rate determines how much you’ll need to pay in interest each year after taking out a loan. For example, if you take out a 30-year mortgage for $300,000 with a 3 percent interest rate, your annual interest payment amounts to $9,000, which means a monthly interest payment of $750.
As you make payments on the loan, the principal balance of the loan will decrease, so while you’ll continue to have a 3 percent interest rate, the amount you pay each month in interest will decrease.
Annual percentage rate (APR)
The annual percentage rate of a loan includes the interest rate as well as the cost of other fees associated with the loan. Some common fees for loans include origination and processing fees. Since the APR includes both the interest rate and the annualized cost of fees, the APR for a loan is higher than its interest rate.
Because fees can vary between different lenders, APR can be a helpful way to compare loans. However, there are other things to consider when comparing mortgages.
How to compare mortgage options
When comparing mortgage options, it’s important to look at the APR, the length of the mortgage, the cost of discount points and how long you plan to stay in the home you’re purchasing.
While annual percentage rates take into account the fees associated with a mortgage, the cost of those fees is spread out over the entire life of the loan. For that reason, you may only benefit from the lower APR if you stay in the home for a certain amount of time.
For example, some mortgages include discount points, which require an up-front cost to lower the interest rate. Initially, these mortgages may actually be more expensive due to the price of the points. However, after reaching a break-even point, a mortgage with a lower APR will save money.
The table below compares the cost of three hypothetical loans with different interest rates, APRs and discount points.
How costs for a 30-year, $300,000 mortgage can vary |
|||
---|---|---|---|
Interest rate | 4% | 3.75% | 3.5% |
Fees | $4,000 | $4,000 | $4,000 |
Discount points | 0 | 1 | 2 |
Points cost | $0 | $3,000 | $6,000 |
APR | 4.11% | 3.94% | 3.77% |
Monthly payment | $1,432.25 | $1,389.35 | $1,347.13 |
Cost after one year | $21,187.00 | $23,672.20 | $26,165.56 |
Cost after three years | $55,561.00 | $57,016.60 | $58,496.68 |
Total cost | $519,610.00 | $507,166.00 | $494,966.80 |
Break-even point | N/A | 69 months | 70 months |
As you can see, a lower APR can lead to significant savings over the course of a loan, but the savings don’t begin immediately. Having a clear understanding of the difference between interest and APR helps when comparing loans, but ultimately you’ll also need to consider how long you plan to stay in your home or whether you’ll refinance your mortgage before you finish paying it off.
Fortunately, securing a mortgage is possible even without excellent credit, especially with government programs like FHA and USDA loans for certain homebuyers. However, finding a mortgage with bad credit can be difficult, so you may want to take some time to build your credit before applying for a mortgage.
If you’ve looked over your credit report and found that inaccurate information is lowering your credit score, consider working with the professionals at Lexington Law Firm to try to repair your credit by filing disputes with the credit bureaus and taking other actions.
Reviewed by Miriam Allred, an Associate Attorney at Lexington Law Firm. Written by Lexington Law Firm.
Miriam Allred was born and raised in Southern California. After high school she joined the US Navy. She then went on to get an Economics degree from Chapman University where she got to enjoy an internship at the United States Supreme Court. Miriam then went to Brigham Young University where she received her Juris Doctor. Prior to joining Lexington Law, Miriam worked as a civil rights attorney dealing with discrimination and sexual harassment. In this role she helped write and create policies and investigate sexual harassment and discrimination complaints. Miriam also has experience in family law. Miriam is licensed to practice in Utah.
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