What’s The Difference Between Interest Rate and Annual Percentage Rate (APR)?
The difference between APR and actual note rate is very confusing, especially for First-Time Home Buyers who haven’t been through the entire closing process before.
When shopping for a new mortgage loan, you may notice an Annual Percentage Rate (APR) advertised next to the note rate. The inclusion of an APR is actually mandated by federal law in order to help give borrowers a standard rule of measurement for comparing the total cost of each loan.
The APR is designed to represent the “true cost of a loan” to the borrower, expressed in the form of a yearly rate to prevent lenders from “hiding” fees and up-front costs behind low advertised rates.
According to Wikipedia:
The terms annual percentage of rate (APR) and nominal APR describe the interest rate for a whole year (annualized), rather than just a monthly fee/rate, as applied on a loan, mortgage, credit card, etc. It is a finance charge expressed as an annual rate.
- The nominal APR is the simple-interest rate (for a year).
- The effective APR is the fee+compound interest rate (calculated across a year)
The nominal APR is calculated as: the rate, for a payment period, multiplied by the number of payment periods in a year.
However, the exact legal definition of “effective APR” can vary greatly, depending on the type of fees included, such as participation fees, loan origination fees, monthly service charges, or late fees.
The effective APR has been called the “mathematically-true” interest rate for each year. The computation for the effective APR, as the fee+compound interest rate, can also vary depending on whether the up-front fees, such as origination or participation fees, are added to the entire amount, or treated as a short-term loan due in the first payment.
What Fees Are Typically Included In APR?
- Origination Fee
- Discount Points
- Buydown funds from the buyer
- Prepaid Mortgage Interest
- Mortgage Insurance Premiums
- Other lender fees (application, underwriting, tax service, etc.)
Since origination fees, discount points, mortgage insurance premiums, prepaid interest and other items may also be required to obtain a mortgage, they need to be included when calculating the APR. Fees such as title insurance, appraisal and credit are not included in calculating the APR.
The APR can vary between lenders and programs due to the fact that the federal law does not clearly define specifically what goes into the calculation.
What Does APR Not Disclose?
- APR on a loan tied to a market index, like a 5/1 ARM, assumes the market index will never change. But Adjustable Rate Mortgages always change over the course of 30 years.
- Balloon Payments
- Prepayment Penalties
- Length of Rate Lock
- Comparison between loan terms – EX: A 15-year term will have a higher APR simply because the fees are amortized over a shorter period of time compared to a similar rate / cost scenario on a 30-year term.
APR Comparing Examples:
- Bank (A) is offering a 30 year fixed mortgage at 8.00% APR
- Bank (B) is offering a 30 year fixed mortgage at 7.00% Note Rate
Easy choice, right?
While Bank (B) is advertising the lowest Note Rate, they’re not factoring in the origination points, underwriting / processing fees and prepaid mortgage interest (first month’s mortgage payment), which could essentially make the APR much higher than the one Bank (A) is advertising. So Bank (A) may show a higher rate due to the APR, but they could actually be charging a lot less in total fees than Bank (B).
Before lenders and mortgage brokers were required to state the APR, it was more difficult to find the truth about the total borrowing costs of one loan vs another. When comparing mortgage rates, it’s a good idea to ask your lender which fees are included in their APR quote.