What's the difference between interest rate and APR?
Even if you're not an expert in the real estate industry, you're probably aware of the various phrases that are synonymous with one another. Whether it's loan and mortgage, buyer and borrower or house and home, there are several terms that are similar in meaning.
Then there's annual percentage rate and interest rate. While there are undoubtedly similarities to both terminologies, their differences are noteworthy. It is important to understand how they contrast and compare. Whereas one is more straightforward in what it describes, the other is more all-encompassing.
For the sake of simplicity, let's start with the likenesses and then move on to what makes them distinct.
How they're alike
Annual percentage rate (APR) and interest rate are written out or described as a percentage. For example, 3.5%.
How they're different
Interest rate is related to the cost of borrowing the funds and one of the factors used to calculate the monthly payment of the mortgage loan. APR is more inclusive, meaning it takes other fees into account, in addition to the interest on the loan. As noted by the Consumer Financial Protection Bureau, these include:
APR’s are usually greater than interest rates because these fees are expressed as a cost over the life of the loan. As noted above, the monthly payment is based on the interest rate, not the APR.
Why are they important to know?
More than anything else, knowing and understanding the APR and interest rate is to increase understanding and transparency of the mortgage loan. It's important to go into any major purchase with your eyes wide open and being aware of both can help you with the decision-making process and how to best approach managing your expenses.
Disclosing the APR and the interest rate as separate and distinct is also the law, mandated by the appropriately named Federal Truth in Lending Act. The TILA authorizes lenders to make borrowers fully aware of these details.
Another reason why it's important to know is to help you avoid sticker shock. Think about any major purchase you've made; you've probably bought something that turned out to be more than initially advertised.
By including the APR into your calculations for how much you can expect to pay, you'll get a better sense of the rock-bottom price when everything is included, above and beyond the list price and the interest rate on the loan itself.
With these details out of the way, here are a few things to be mindful of when you're evaluating the APR and what you'll spend from month to month, as referenced by the CFPB:
APR has limitations
In addition to terms and phrases, the homebuying process is filled with choices, one of which is whether you select a fixed-rate mortgage or variable interest. If you choose the latter, it means that the interest on what you spend could change over the life of the loan, thus impacting how much you spend per month. Understand that APR can't predict the future, so the APR has its limitations when it comes to measuring how much you can expect to pay should interest rates fluctuate.
Compare apples to apples
Fixed-rate loans and adjustable-rate loans, while similar, are two different animals in terms of how they operate and are calculated. Therefore, comparing the APR of an ARM with the APR of a fixed-rate loan may be difficult to draw any broad-based conclusions, even if one is higher than the other. Instead, it's best to judge the APR when measured up against the same loan type (i.e. fixed to fixed, ARM to ARM).
The same goes for the APR of a closed-end loan and the APR of a home equity line of credit, or HELOC. Fees aren't included in the APR figure for the latter.
If you have any concerns or points of confusion about buying a home, please contact us at Residential Mortgage Services. The only silly question is the one that's unasked.