Mortgage Interest Rate vs APR – What is the difference?

If you’ve ever taken a loan or applied for a credit card, you’ve probably seen the term annual percentage rate or APR. When it comes to mortgages the APR is a percentage, it’s usually right next to the interest rate and looks awfully similar. You might find yourself thinking “what’s the difference between the mortgage interest rate and APR?” You’ve come to the right place, we’re here to help!

 

Are interest and APR the same thing?

Let’s get this out of the way at the start – annual percentage rate (also known as APR) and interest rate are not the same things. This can be confusing because they’re very related, and they’re often presented together. They are very different numbers, however, and they serve different purposes.

 

What is a mortgage interest rate?

We’ll start with the basics – an interest rate is an amount charged to a borrower on an annual basis in exchange for use of an asset. It’s an annual fee for borrowing. In this case of a mortgage, the “asset” is a pile of money used to buy your house. This fee is displayed as a percentage of the total amount.

For example, say you borrowed $1,000 from your buddy for a year, and she charged you $100 per year. To calculate your interest rate you would take the $100 fee divided by the $1,000 total loan, which would be a 10% interest rate for the year.

 

What is the annual percentage rate?

Annual percentage rate, on the other hand, is a way to measure the total cost of your loan over time. It takes into account the interest charged on a loan as well as any additional fees – like upfront fees you pay as cash.

Take our same example above, but now in addition to the $100 per year fee your friend also charges you a  $50 upfront fee that you must pay when they give you the money to borrow. Your interest rate will still be 10% because that is the annual cost of borrowing the money. But the APR takes into account the upfront cost of $50 as well as the annual cost, so the APR is a higher rate of about 10.6%.

 

What is the difference between APR and interest rate on a home loan?

The CFPB puts it best:

The interest rate is the cost you will pay each year to borrow the money, expressed as a percentage rate. It does not reflect fees or any other charges you may have to pay for the loan.

An annual percentage rate (APR) is a broader measure of the cost to you of borrowing money, also expressed as a percentage rate. In general, the APR reflects not only the interest rate but also any points, mortgage broker fees, and other charges that you pay to get the loan. For that reason, your APR is usually higher than your interest rate.

When it comes to mortgages, both of these numbers are important. Buying a home can mean paying a lot of fees and taxes that are included in your cash to close amount – transfer taxes, property taxes, lender fees, mortgage points, fees for the home appraisal, and more.

In these cases, the APR of the loan is the best thing to focus on. Because it takes all of these fees into account it’s good for comparing loans from two lenders in an apples-to-apples way. This is why most sites like LendingTree present APR in their comparison tables.

Enter your information into the calculator below and you can see how your personalized interest rate differs from the APR.

 

Where do mortgage interest rates come from?

Mortgage interest rates are tied to the bond market. When a mortgage company gives you a loan, they package that loan up with a bunch of other loans, and they sell it as an investment. This is called a mortgage-backed security. Like anything else, if lots of investors are buying mortgage-backed securities, the price goes up. If there aren’t many buyers, the price goes down.

This mortgage-backed security has to compete against other investments in the marketplace. An investor could buy some mortgages, but they could also buy stocks or bonds. Since most people either sell their home or refinance their loan within 10 years of purchasing, mortgage-backed securities often compete with the 10 year treasury note interest rate. As a result, they tend to move together.

US 30 Year Mortgage Rate Chart

US 30 Year Mortgage Rate data by YCharts

Treasury bills are 100% insured by the government. There is very little risk, the investor is guaranteed to get their money back as long as the US government does not go bankrupt. Because mortgage debt is only partially secured by the home (up to that loan-to-value mark), there is some additional risk, so the interest rates for mortgages are always a bit higher than the treasury note rate.

The important thing to understand is generally as the treasury note rate goes up, mortgage interest rates go up. As the note rate goes down, mortgage interest rates go down. And they tend to move frequently, updating over the course of the day even! But why is that?

 

Why do mortgage interest rates move?

Mortgage interest rates are a very peculiar thing – no one really for sure knows whether they’ll go up or down. Almost everyone has an opinion on what’s going to happen, but no one can really know. Rather than listening to talking heads or reading opinion articles, a better approach is to understand (roughly) what affects the mortgage interest rates and how that affects your ability to buy a home.

Contrary to what many believe, the mortgage interest rate is not tied to the Federal Reserve rate, at least not directly.

The Federal Reserve (aka the Fed) sets the Federal Funds Rate, which is the rate at which banks lend money to one another. It’s a complex topic, the curious can dig in here. The board of directors for the Federal Reserve meet on a regular basis and set the Federal Funds Rate. When they meet it’s a highly discussed event – wall street watches very closely and it gets a lot of press coverage. And in many cases they discuss what it means for mortgages.

But the important thing to know is that a higher rate from the Federal reserve doesn’t necessarily mean mortgage rates will go up. Take a look at the chart – the 30 year mortgage rate moves generally in the same direction as the Fed Rate, but they don’t move completely in sync.

US 30 Year Mortgage Rate Chart

US 30 Year Mortgage Rate data by YCharts

When the Fed changes rates up or down, it’s more of a signal than anything else. They change the rate based on key economic indicators like job growth, wage growth, and a bunch of other indicators that point to the strength of the economy.

It’s also a signal about inflation or deflation of the dollar, which is why we care. As inflation goes up, the value of a dollar goes down. A loaf of bread used to be $2, now it’s $4 for the same loaf – you can thank inflation for that. A house that was $200,000 in 1990 would cost $362,688.20 in 2015 – that’s just inflation alone, not accounting for any property or market factors. The Bureau of Labor Statistics has an interesting (and unfortunately very ugly) inflation calculator you can play with here. Plug in some dates and a dollar amount and you can see how the value of that money has changed over time.

The interest rate for the 10 year treasury note adjusts with inflation. Because of this, mortgage rates must adjust to stay competitive as an investment. Mortgage rates are not directly tied to this Fed rate, but they can be affected by it. When the Fed manipulates their rate it can drive the 10 year treasury rate up or down, changing the mortgage interest rates with it.

This is a really complex topic and there are many people that write about this. I’m not going to spend much more time here, but if you want to learn more, there are pretty good articles you can read here and here.

 

Can I get a better interest rate?

The base interest rates for most loans are publicly available – this is often the advertised rate (or “teaser rate”) that you’ll see from most lenders. This is usually the 30 year fixed mortgage interest rate.

There are other factors that can adjust your interest rate up or down from the advertised rate, and they all have to do with risk. The more risk the mortgage company has when lending you money, the higher your interest rate. The major factors are –

  • Credit score -This is a big one. The lower your credit score, the more risky your loan seems, and the lender adjusts the interest rate accordingly. This has become a problem for young people who don’t use things like credit cards – their credit scores are artificially low, making them seem more risky then they actually are.
  • Loan term (aka Amortization) – The shorter your loan is, the quicker the loan is paid off, which lessens risk. That is why 15 year loans have a much lower interest rate than 30 year loans.
  • Loan to Value Ratio – we discussed a few scenarios explaining how the LTV ratio is a good measure of risk. As the LTV goes up, and the borrower puts less cash down, the more risky the loan is for the lender. To account for that risk, ask LTV goes up, so does the interest rate on the loan.

 

How Interest Rates Affect Home Affordability

It’s pretty straightforward – the higher your interest rate, the lower your maximum mortgage amount you can afford. You can check out our mortgage affordability calculator to see how changing your interest rate impacts your maximum home purchase price.

Assume your max purchase price is based on a 43% debt-to-income ratio. If your interest rate is higher, a larger portion of your monthly mortgage payment goes to paying interest every month, leaving less to pay for the principal amount, and lowering your affordability. You can see this in action below:

mortgage interest rate comparison

As you can see, a small move in interest rates can have a huge effect on your affordability. In this example, an increase of half a percentage point (.5%) translates to a nearly $20,000 loss in affordability.

But what if you don’t care about your max purchase price? Say you have your eye on a certain home in particular – rising interest rates can make the same house cost more per month. Consider a $200,000 home with two different interest rates.

interest rate payment comparison

In this example, an increase of half a percentage point leads to an increase of $58.54 every month. That may seem minor, but over 12 months that comes to $702.48. After 5 years, that small interest rate increase means an extra $3,512.40 in monthly payments – it adds up quickly!

 

Other Factors That Affect Your Mortgage Rate and APR

There are a couple of decisions you can make during the loan process that will affect your interest rate. Luckily, these are completely within your control, and they exist for your benefit.

Rolling closing costs into the loan – we’ve covered this in more depth in our explanation of closing costs, but for borrowers who want to conserve cash, you can choose to not pay your fees with cash. Instead, the lender will raise your interest rate slightly to compensate.

Buying down points – this is basically the opposite of a no-cost loan. If you pay the lender cash up front, they will gladly lower your interest rate. This is a great option for someone with a large cash reserve who is more concerned with lowering their monthly payments. This can also be great for someone who plans on staying in the home for a very long time – lowering your rate up front can save you 10’s if not 100’s of thousands of dollars over the lifetime of the loan.

 

Interest Rate Wrap Up

If you only remember two things from this entire guide, I hope it’s these points:

  • Fixed rate loans and variable rate loans (also called adjustable rate mortgages) are significantly different. Before signing up for a home loan with an adjustable rate, make sure you understand the long-term implications.
  • Interest rates are powerful – agreeing to a small increase in the interest rate during the mortgage process can mean thousands of dollars (or tens of thousands!) in increased costs over the life of the loan.

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