The two main ways lenders sum up the cost of a mortgage are the interest rate and the annual percentage rate, or APR. The interest rate tells you how much the lender will charge you to borrow money to buy a home, while APR includes the interest rate and loan fees. Knowing the difference between these rates is important for homebuyers to understand when comparing loan offers from lenders.
Key Takeaways:
- The interest rate on a mortgage determines how much you pay the lender to borrow money.
- APR includes the interest rate and other loan costs.
- It’s important to understand the difference between these figures to effectively compare loan offers directly and to make sure you get the best deal on a mortgage.
What Is the Interest Rate on a Mortgage?
The interest rate on a mortgage determines how much you must repay the lender to borrow the principal. The rate is expressed as a percentage of the amount owed. Lower rates mean you pay less to the mortgage lender to borrow money.
That sounds simple, but the math behind interest rates is complicated by how frequently you make payments on the loan and how often the interest rate is used to calculate the amount you must pay.
Interest rates even a bit lower can save you a lot of money over the life of your loan.
For example, imagine you get a $400,000 fixed-rate mortgage at 7% interest. Your monthly payment will be $2,661. Over 30 years, you’ll pay $958,036 to pay off the loan, including $558,036 in interest.
Drop the interest rate to 6% and the monthly payment goes down to $2,398. The total cost of the loan will be $863,353 — saving you nearly $95,000 over the life of the loan.
How Interest Rates Determine Your Loan Payment
On a mortgage, the interest rate is used to calculate how much of your monthly payment is interest and how much is applied to the loan balance. Since mortgage payments are usually due monthly, the interest rate is applied to the principal each month.
Mortgage payments are calculated using amortization, which determines how much your payment is, how much of it goes to interest, and how much is applied to your loan balance.
At the start, most of your payment goes toward interest. Over time, the amount of interest you pay on each payment decreases. It takes a little more than 10 years before more of each payment goes toward the balance of your loan than interest. Near the end of your repayment schedule, you’ll be paying almost all principal and little interest.
Amortization on a 30-year $400,000 Fixed-Rate Loan at 7% Interest
| Payment Number | Payment Amount | Interest | Principal | Ending Balance |
| 1 | $2,661 | $2,333 | $328 | $399,672 |
| 2 | $2,661 | $2,331 | $330 | $399,342 |
| 3 | $2,661 | $2,329 | $332 | $399,011 |
| 4 | $2,661 | $2,328 | $334 | $398,677 |
| 5 | $2,661 | $2,326 | $336 | $398,341 |
| — | — | — | — | — |
| 356 | $2,661 | $76 | $2,585 | $10,491 |
| 357 | $2,661 | $61 | $2,600 | $7,891 |
| 358 | $2,661 | $46 | $2,615 | $5,276 |
| 359 | $2,661 | $31 | $2,630 | $2,646 |
| 360 | $2,661 | $15 | $2,646 | $0 |
If you have an adjustable-rate mortgage, your payment amount will increase or decrease based on how your interest rate changes. If your loan adjusts annually, the rate it adjusts to will be used to calculate the interest you pay until next year’s adjustment.
Most homeowners use an escrow account or impound account to collect money each month to cover their estimated property tax and homeowners insurance bills. That amount is paid in addition to the amortized loan payment.
How Are Interest Rates Determined?
Broad economic factors and your personal finances affect the interest rate mortgage lenders will offer you.
Economic factors affecting interest rates
Mortgage interest rates are most broadly determined by the overall economy.
Federal funds rate
The federal funds rate is the interest rate banks charge each other for overnight loans. This rate is heavily influenced by the Federal Open Market Committee, a policy-making panel of the Federal Reserve. The lower the federal funds rate, the cheaper it is for banks to borrow money, and the lower the mortgage rates they can offer their customers.
Secondary mortgage markets
Lenders sell conforming conventional loans to Fannie Mae or Freddie Mac, which package those loans into mortgage-backed securities and sell them to investors on secondary markets. If investors are eager to buy mortgage-backed securities, interest rates usually decline. If demand is low, lenders may raise rates to offer those investors a better return.
Overall economic health
When inflation and unemployment are low, rates tend to decrease because the economy is robust enough for borrowers to reliably pay their mortgages. When those factors increase, lenders may raise rates to compensate for the increased risk that borrowers may default on their loans.
Personal factors affecting interest rates
In addition to market conditions, your finances affect the interest rate your lender will offer you. Factors likely to earn you an offer of a lower interest rate include:
- A higher credit score.
- A larger down payment.
- A lower debt-to-income ratio.
- Whether you plan to live in the home as your primary residence.
- The type of mortgage you’re applying for.
What Is APR on a Mortgage?
The interest rate on your loan is only one part of its overall cost. You also may pay for discount points that reduce your interest rate, fees your lender may charge to process and underwrite your loan, plus closing costs to complete the sale.
By including those costs, APR can give you a better idea of the total you’ll pay for your loan. That means APRs typically are a higher number than interest rates.
When your lender provides you with the loan estimate, it will include the interest rate and APR, letting you quickly compare the overall cost of similar loans.
How is APR determined?
APR typically includes charges such as:
- Mortgage points.
- Broker fees.
- Origination fees.
- Attorney fees.
- Closing costs.
- Document preparation fees.
- Home inspection fees.
- Rate lock fees.
- Title service fees.
Ask lenders which fees and costs they include in their APR calculations. If lenders use different fees when calculating the APR on otherwise identical loans, the APRs may not be directly comparable.
What Is the Difference Between Interest Rate and APR?
Both interest rates and APR are used to describe the cost of a loan. The difference is in what costs they account for.
“The interest rate is a percentage of your loan that you pay for borrowing the money. It’s essentially the cost of the loan itself, without considering any additional fees or charges. This is the rate that affects your monthly mortgage payments,” says Reed Letson, branch manager of Elevation Mortgage, a Suwanee, Georgia-based lender. “The APR is a broader measure of the cost of borrowing. It includes the interest rate but also takes into account other costs associated with the loan, such as broker fees, discount points, and some closing costs. The APR is expressed as a yearly rate and gives you a more comprehensive picture of the total cost of the loan.”
That makes the APR of a loan a more comprehensive representation of a loan’s cost. If you’re comparing two loans, the APR will show if a lender compensates for a low interest rate with high fees.
Comparing APR vs. Interest Rate
Imagine that you want to borrow $300,000 to buy a home. You apply for a 30-year fixed-rate loan with two different lenders and receive two offers.
Comparing Mortgage Terms and APR
| Loan A | Loan B | |
| Loan Amount | $300,000 | $300,000 |
| Interest Rate | 6.25% | 6% |
| Discount Points | 0.5 | 2 |
| Other Fees | $6,000 | $12,000 |
| APR | 6.447% | 6.587% |
Even though Loan B has a lower interest rate than Loan A, the upfront costs for points and fees mean it has a higher APR.
It’s important to take care when comparing APRs that the terms of the loan and the included fees are the same. Loans with different repayment terms or fees will not have comparable APRs.
FAQ: Interest Rate vs. APR
Here are answers to common questions about the difference between APR and interest rate.
You should look at both. APR provides a fuller picture of the price of a loan because it incorporates both the interest rate of the loan as well as its fees. However, loans that differ in repayment terms or in which fees are included in the APR cannot be directly compared.
Yes. If you have an adjustable-rate mortgage, the APR will change along with the interest rate.
Yes, the interest rate and APR can be the same. For example, if the loan charges no additional fees, its APR may be the same as its interest rate.
The Bottom Line on Interest Rate vs. APR
Interest rate and APR are two ways of expressing mortgage costs. Interest rate focuses on the ongoing cost of borrowing and APR accounts for any fees that might be added to the loan. Because APR looks at more costs, it can provide a clearer picture of the cost of borrowing when comparing two loans.
