What’s the Difference Between Interest Rate & APR? Your Mortgage Questions, Answered
May 14, 2019
Thinking about buying a house? Before you start looking at paint swatches and perusing Pinterest boards for inspiration, it’s time to do your research on mortgages.
For most people, buying a house is one of the biggest investments of their lifetime. The process of getting a mortgage is complex, but it doesn’t have to be confusing. Wondering what’s the difference between an interest rate and APR? Or if you should choose a fixed rate or adjustable rate mortgage? And how does your credit score fit into this whole process?
Get these three mortgage questions answered below.
What’s the difference between an Interest rate and APR?
Let’s get this straight. While interest rates and APRs are similar, they are not synonymous terms.
The interest rate is the cost of borrowing the principal loan amount—or the amount of money you want to get from the bank. The interest rate can be a variable or fixed rate, but it’s always just the percentage of interest you will pay on the principal loan. Your interest rate is determined by industry interest rates and your credit score.
The APR (annual percentage rate) includes the interest rate above, as well as other associated costs that go with the mortgage. This can include things like broker fees and closing costs. You should always find out exactly what is and isn’t included in the APR, since some lenders may not include appraisal and inspection fees in the APR. The APR is determined by the lender. Additionally, the Federal Truth in Lending Act requires that the APR should be clearly disclosed in every consumer loan agreement.
Your monthly mortgage payment is determined by your interest rate and the amount of the principal balance you have left in the loan. Think of the interest rate as a helpful way to determine your monthly mortgage payments, while the APR is a bigger picture look at the cost of the loan as a whole.
When researching different mortgages, you’ll find lenders that offer you different APRs. If you’re looking for a long-term home, loans with a lower APR might make more sense. Lower APRs spread out fees over the length of the whole loan, so they’re the most valuable over time. However, if you’re looking to stay in a home for a shorter time, a higher APR might be better for you since there are fewer fees up front.
Of course, this is a big decision so make sure to take your time and consult all of your options.
Why does credit score matter for your mortgage rate?
As mentioned above, your credit score directly affects your interest rate. Lenders like to see a low debt-to-income ratio, a higher credit score, and a strong financial history. When you have a higher credit score, you’ll likely get a lower interest rate.
A strong credit score signifies to the lender that you have a history of timely payments and responsibility. This makes it more appealing for the lender to grant you the loan.
On first glance, interest rates may seem similar—but even a difference of .25% can add up to a lot of money over the years.
Take this example from NerdWallet. Say a borrower wants to buy a $300,000 home with a 30-year fixed rate loan for $240,000. The borrower has a very strong credit score of 780, which gives her a 4% interest rate. This principal loan and interest rate add up to approximately a $1,164 monthly payment.
But what if the borrower had a credit score of 680? This would give her an interest rate of 4.25%, which means the monthly payments jump to $1,216 per month. This might seem like a slight difference, but it equals an additional $25,300 paid in interest over this 30-year time span.
There is no golden rule for what your credit score needs to be to get a good mortgage interest rate, but it’s recommended to be in the 700 range. Get some tips on raising your credit score here.
What’s the deal with fixed rate and adjustable rate mortgages?
Fixed rate and adjustable rate mortgages (ARMs) are the two types of mortgages you can get.
A fixed rate mortgage means that your interest rate remains the same throughout the length of the loan. While the amount of principal loan and interest you’re paying from payment to payment, every monthly payment will be the same. Typical fixed rate mortgages are for either 15-, 20-, or 30-year time spans. The 30-year fixed rate mortgage is the most popular since it has the lowest monthly payments. However, this 30-year fixed rate mortgage also costs the most overall since you end up paying more in interest over time.
An adjustable rate mortgage has a variable interest that fluctuates throughout the span of the loan. Typically, the initial interest rate is set below the market rate at the time of the loan. As time goes by, the interest rate increases. New interest rates are reset based on current market rates.
Not sure what type of mortgage is right for you? A fixed rate mortgage makes budgeting easier for homeowners since your monthly payments are always steady. Plus, a fixed rate mortgage protects you from payment increases if market interest rates rise.
Meanwhile, if you have an ARM for a long time, it’s likely that you’ll end up with interest rates higher than fixed rate loans. Also, ARM monthly payments can vary a lot. However, one of the advantages of the ARM is that it has lower initial payments.
Like choosing between a lower or higher APR, choosing between a fixed rate and adjustable rate mortgage is a big decision. Consider what you can afford now in monthly payments, how long you plan to live in the house, and how interest rates are trending to help you decide.
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