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Mortgage Rate vs. APR: What's the Difference?

When you shop for mortgages, you'll find that the annual percentage rate (APR) will always be a higher number than the plain interest rate. This is because APR takes into account the total cost of borrowing money, expressed as a percentage of the amount you borrow. You can use the interest rate on a mortgage to calculate how your monthly payments will be divided between principal and interest.

How Is APR Different From a Mortgage Interest Rate?

For a mortgage, both the interest rate and the APR are expressed in annual terms. However, APR will always appear as a higher number because it accounts for mortgage closing costs.

Mortgage APRMortgage Interest Rate
  • Accounts for closing costs
  • Gives a better picture of overall expenses
  • Will change if you sell or refinance
  • Useful for calculating amortization
  • Doesn't include upfront expenses
  • Stays the same regardless of term length

Basically, APR is meant to help consumers understand the total cost of a loan product, including all upfront expenses. All mortgage lenders charge different amounts in closing fees, but the law requires all of them to express those costs in the annual percentage rate. Nevertheless, you'll find that different lenders include different costs. Third-party fees like appraisals, for instance, are usually excluded from the lender's APR.

Calculating the APR on Your Mortgage

To show how the APR on a mortgage is different from its interest rate, we calculated the APR for mortgages with different combinations of balance, term and closing costs.

Mortgage BalanceRateTermClosing CostsAPR
$200,0004%30y$5,0005.96%
$200,0004%30y$4,0005.57%
$200,0004%15y$4,0007.01%
$150,0004%15y$4,0008.01%

Although we kept the interest rate at 4% in each example, adjusting any one of the other factors resulted in a unique APR for that mortgage. Lower closing costs result in a lower APR because such fees raise the final price of your mortgage loan, while a shorter term of 15 years raises the APR by condensing your repayment into half as many years. Finally, reducing the original mortgage balance while keeping all other variables the same shows how APR is also affected by changes in the amount of credit you receive.

The US Treasury provides a free program called APRWIN that calculates the actuarial APR based on user-provided values for mortgage rate, amount and term length. Mortgage lenders and regulators frequently rely on APRWIN to confirm that advertised APRs are accurate and in compliance with federal rules. This program and other online tools represent the most accessible way to estimate your own APR. However, you should remember that APR can change completely if you decide to cut your mortgage short by selling your home or refinancing your mortgage.

Actuarial Method vs. US Rule Method: Which APR Do Lenders Use?

A bigger problem with APR is that federal law allows lenders to calculate it in two different ways. Regulation Z, better known as the Truth in Lending Act, accepts both the actuarial method of calculation and the United States Rule method. The actuarial method accounts for compounding interest, while the US Rule Method does not. Most lenders rely on the actuarial method, which follows a clear formula defined by the law. In contrast, the US Rule Method is much more complex, resulting in greater risk of error.

However, lenders who offer mortgages with long first periods must use the US Rule. This is because an extended first period inflates the first mortgage payment thanks to the longer period of accumulating interest. If a mortgage with a long first period relies on an APR calculated by the actuarial method, then the extra compounding may cause the first interest payment to be larger than the actual scheduled payment, resulting in negative amortization. Finally, federal rules for APR also permit a margin of error. Any APR advertised by a lender is considered accurate as long as it falls within 1/8th of 1 percentage point of the actual figure.

Should You Shop Based on Interest Rates or Mortgage APR?

Before you make a decision between interest rate and APR as a tool for shopping mortgages, you should narrow down the variables involved. While rates will be slightly different everywhere, you can reasonably expect to control how much money you borrow and how long you'll take to pay it all back. Determining whether you want a fixed or variable rate mortgage will also affect the choice between interest rates and APR, since the APR that lenders display for ARM loans can change when the interest rate starts to adjust later in the term.

In general, you should spend the extra time to calculate your own mortgage costs based on the interest rate of each mortgage you look at and the closing costs. This task becomes much easier if you limit your shopping to a certain type of mortgage: for example, comparing 30-year fixed rate mortgages at the same price point is much faster than trying to figure out the relative costs of a 15-year mortgage against a 5/1 ARM. APR may be an easy summary of your potential costs, but it's still subject to variations from the different methods preferred by each mortgage lender.

If you're planning on selling your home or refinancing before the end of the mortgage, APR will be far less accurate for measuring your costs. Because the calculation of APR adds in the upfront costs of your mortgage and then spreads that expense evenly over all the years of the full term, you'll be underestimating the true cost of the mortgage when you decide on leaving early. That makes it all the more important to rely on base interest rates and do the math with your projected refinance or selling date in mind.

Sources

Truth in Lending Act, §226.22

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