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Mortgage interest rate and mortgage APR (annual percentage rate) while related, are not the same. You’ll see both listed for mortgages. For example, you may see a 30-year fixed-rate mortgage with an interest rate of 4.250% and an APR of 4.385%. The interest rate is the interest you pay on your home loan. The APR is the interest rate plus other fees and costs associated with buying a home. APR is really what you’ll pay on top of the principal. It’s sometimes called the percentage rate.

The federal government supports the annual percentage rate (APR) disclosure as the benchmark barometer of a loan’s cost when mortgage shoppers begin their quest to find a good deal on a home loan. For this reason, it’s important to understand what goes into a mortgage APR and to harness this knowledge to find the best loan for you.

APR Decoded

The APR you pay on your mortgage includes:

If you have a higher APR, then you can expect to make higher monthly for the term of your loan. You also want to really compare APRs and not just the flat interest rate. You want a better interest rate and APR, but the APR is really what you’ll pay, so the better the APR, the better your mortgage.

APR Versus Interest Rates

The interest rate is a percentage against the total loan amount that the mortgage lender charges each year in exchange for loaning the money the borrower.

The APR, on the other hand, is that interest, plus some other charges. With a home, those charges include the items listed above. APR is used primarily for fixed-rate mortgages.  The APR on an adjustable-rate mortgage (ARM) is a forecast only, which is often inaccurate.

Say you loan your nephew $500 to buy a new bike. In exchange, he agrees to pay you back in six months. You charge him a 5% interest rate—each month—for the favor. The interest and payments break down like this:

  • Interest Rate—5%
  • APR—0%
  • Monthly Payment—$84.55
  • Total Cost—$507.32
  • Interest Payments—$7.32

So your nephew’s interest is $7.32. That’s simply the money he’ll pay you for your loaning him the money.

Using your loan to your nephew as an example. Let’s say, you’re a tough uncle or aunt and you tell your nephew that you’re going to charge him a $20 fee on top of the interest in exchange for giving him the loan. The interest doesn’t apply to that $20 charge, but that charge is paid out over the course of the loan as part of the monthly payment rather than up front or when the loan is paid off. The payments with APR breaks down like this:

  • Interest Rate—5%
  • APR—18.6916%
  • Monthly Payment—$87.93
  • Total Cost—$527.61
  • Interest Payments —$7.61

The same scenario applies to your home loan. You pay interest and you pay APR. But what you really pay is the APR, which includes the interest and is your total cost of borrowing.

Keep in mind that there are charges that don’t go into the APR category, such as closing costs, which aren’t included in APR.

How APR Affects Your Mortgage

The APR helps you evaluate the true cost of borrowing the money for buying your home. It actually also helps you spread the costs of that purchase out.

Let’s look at your nephew again. Say, he buys at the bike under the 18.6916% APR scenario. He decides after two months to sell it. At that point. He’s paid you $175.86 toward the loan, $6.76 of which covers the $20 fee you’re charging him for the loan. He sells the bike for $400. He pays you the remaining principal left on the loan, which is $334.72. But, because he spread the $20 fee out over the life of the loans, he’s actually saving $13.24 compared to if he had paid that and upfront $20 fee.

The moral of the story is that APR helps spread costs out across your monthly mortgage payments for the long haul and it benefits you if you if you end up selling your home earlier. You could pay less interest if you paid all the fees associated for the loan up front, but if you need to sell early, you lose money.

Knowing the APR lets you measure how much interest you end up paying in the long run. It also lets you compare loan products and fees to see how you can save money over the term of your loan.

APR Tips and Tidbits

APR is disclosed for a new loan or credit products. You won’t, however, see APR on your monthly mortgage loan statement as the APR is used as a cost measure when you first apply.  The sole purpose of APR disclosure is to make mortgage shopping easier. The APR doesn’t change the amount you borrow.

A loan calculator, or amortization schedule calculator, offers a simple way to estimate your monthly loan payments. It also shows how much of each of your payments go to the interest of the mortgage loan as well as the principal (the actual amount you borrowed).

Be attentive if the APR is more than 0.25% higher than the interest rate for a loan. If you receive disclosures that show a substantially higher APR than the interest rate and you don’t understand the disparity between the ARP on your disclosures and/or mortgage quote versus the interest rate, ask your loan officer. Don’t be afraid to ask questions even if they seem silly or redundant.

Keep in mind that one of the biggest factors in what determines the interest rate you end up paying is your credit score. Taking some time before applying for a mortgage to build a good credit score can save you thousands over the life of your loan from a lower interest rate. You can check your credit score for free on Credit.com to see where you stand and use the free credit report card that comes with your score to improve your score over time.

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This article was last published May 20, 2015, and has since been updated by another author.

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