The difference between mortgage interest rates and APR explained

The Annual Percentage Rate is the true cost of borrowing money

The Annual Percentage Rate (APR) of your mortgage is what you’ll pay annually for your loan after fees, points, or other charges to your loan. To understand APR, remember that the interest rate your lender charges you is the rate applied to the principal loan amount. It doesn’t include the actual amount you’ll pay in interest after you factor in additional fees, discount points, or other charges.

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How the annual percentage rate works

Most mortgage lenders and programs require that you pay certain fees to secure the loan. For most borrowers, these can be as simple as a 1% origination fee. But for other types of mortgages, you could pay cash for a mortgage discount point or monthly premiums for private mortgage insurance (PMI).

The APR combines these fees and discounts into the more accurate yearly cost of paying for your home loan.

How is APR calculated?

Imagine you borrow $500,000 to buy your new home. Now, let’s say your lender offers you that loan at 4% interest, for a 30-year fixed rate. The basic monthly interest payments would be $2,387 each month.

But to start the loan (an origination fee), you have to pay 1% of the loan, or $5,000. Now, you’re out $5,000 before the loan even starts. Your lender’s investment is down to $495,000 but you’re still paying $2,387 each month—an APR of 4.083%.

To calculate your APR:

Step 1: Use your loan amount and interest rate to determine your monthly payment. So, if your loan is $500,000 at 4% interest over 30 years, your monthly principal and interest payment would be $2387 each month.

Step 2: Using the same monthly payment and net amount financed, work backwards to get your APR. With a $2387/month payment and actually only borrowing $495,000, your actual cost is at a rate of 4.083%—this is your APR.

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All calculations are estimates and provided for informational purposes only. Actual amounts may vary.

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Choosing a lender

Only focusing on interest rates when choosing a lender can be a flawed strategy. One lender may offer you an interest rate of 3.25% and another may offer you an interest rate of 3.99% for the same loan scenario. While you might be tempted to choose the lower interest rate, you’re only seeing a small part of the picture. You don’t yet see how much either of those rates will end up costing you.

This is where the Annual Percentage Rate, or APR, comes into play.

Any time your lender advertises or quotes an interest rate and monthly payment amount, they are also required to disclose to the APR.

Fees that are included in the APR may include:

  • Origination and discount points
  • Processing and underwriting
  • Escrow fees
  • PMI

Since these fees can vary from lender to lender, the APR is a great gauge for how expensive a loan will actually be. Assuming you’re comparing two loans with the same terms and interest rate, the higher the APR, the more you’re paying for that loan.

Disclosure also helps to hold your lender accountable. Your lender is not permitted to increase your APR by more than 0.125% without providing at least 3 days advance notice. This is meant to eliminate any cost surprises when you close on your mortgage loan.

When APR really matters

Since the interest rate stays constant in a fixed-rate mortgage for the entire life of the loan, the APR is usually close to the interest rate. This changes, though, if you pay PMI to secure a mortgage with a down payment less than 20% of the home’s purchase price.

If you choose an adjustable rate mortgage (ARM), the APR will also include interest rate adjustments. But since your lender won’t know these exact adjustments at the time you are taking out the mortgage, their APR uses the worst-case outcome where your interest increases to the maximum allowed under that program.

How to use APR to make your decision

The lower your APR, the less you pay in both interest and fees for the mortgage.

If you plan to keep the home for a long time, it generally makes sense to take the loan with the lowest APR as it means your long-term cost will be the lowest.

If you plan to keep the home for only a short time, pay extra attention to the gap between the interest rate and the APR. A large gap may indicate a high amount of upfront costs due at closing, which means you may not be the best route given that you plan to sell in the short term.

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