What’s the difference between interest rate and APR?
APR vs interest rate: What’s the difference?
An interest rate tells you how much interest you’ll pay each year, while an APR captures the full cost of borrowing, including closing costs and any mortgage insurance.
Occasionally, the two figures are the same, because the loan came with no added costs. But, usually, the APR is higher because most loans have at least some additional fees. That means when you’re comparing offers for two loans, the APR is incredibly useful — generally more so than the bare interest rate.
What is a mortgage interest rate?
Your mortgage interest rate tells you the percent of the loan amount you’ll pay in exchange for borrowing money to buy a house.
On the day this was written, the average rate for a fixed-rate, 30-year VA loan was 2.625%. But what does that 2.625% actually mean?
For the purpose of this example, let’s suppose you borrowed $100,000 through a VA loan. If you had a rate of 1%, you’d be paying one-100th of that amount in interest each year, which is $1,000. With a rate of 2.65%, you’d pay $2,650. Our mortgage calculator can do the math for you.
Amortization & how it affects your mortgage
The great thing about fixed-rate mortgages is that your interest rate and monthly payments are fixed for the life of your loan. But, behind the scenes, your payments are treated differently over the term of the loan.
For the first year, you’re paying interest on the full balance of your loan, which means much of your mortgage payment is covering interest and not much is paying down your loan principal.
But, gradually, your mortgage balance reduces. This means a smaller percentage of your mortgage payment is going toward interest every year — and more is going toward reducing the debt. By the final year of your loan term, you owe only a few thousand. And the interest on that is minimal. So almost all the money you pay in the last year goes to reducing your debt down to zero. This whole process is called “amortization.”
What is an APR?
The biggest part of an APR is nearly always the interest rate, but it includes all your other loan costs, too.
When you have a VA loan, the costs rolled into the APR include:
- Lenders fees
- Third party fees, like appraisal and title insurance
- VA funding fee
That means your APR will always be higher than your interest rate.
So an APR expresses all the costs associated with your loan — including the ones you probably already paid at closing — as an annual rate. It tells you how much you’re going to pay in total for your borrowing, and that can help you instantly differentiate between the loans with the lowest rates and the ones that might actually be better deals overall.
How to shop for a mortgage using an APR
In the old days, some unscrupulous lenders would attract borrowers by advertising fantastically low-interest rates and then make up the difference with extortionate fees and costs, often buried in the small print.
The Truth in Lending Act of 1968 closed those loopholes. It both introduced and mandated APR, which helped improve transparency for borrowers.
APR is a useful tool for you to compare loan options when you’re shopping for a VA loan.
Don’t compare the APRs for different loan types
As you’re shopping for a VA loan, you might decide to check out adjustable-rate mortgages (ARMs) and 15-year loans in addition to the more usual 30-year, fixed-rate mortgage (FRM). That’s great, but don’t make the mistake of comparing APRs for different sorts of loans. That’s like comparing apples with oranges.
So compare the APRs on all your quotes for 30-year FRMs only with each other. And the same goes for other types of loans. Compare apples with apples.
Be careful when using APR to compare ARMs
APRs are less useful when comparing ARMs. That’s because the interest rates (nearly every APR’s biggest component) can change after the introductory, fixed-rate period.
For these loans, you’re better off digging into the quote to compare caps that limit how much your rate can move. There is often an annual cap limiting the amount your rate can increase each year, and another cap limiting how much a rate can rise in total over the term of the loan.
Why the lowest APR may not be best for you
An APR doesn’t tell you which loan is the best choice for your situation. It’s a tool to help you weigh your options.
You might have plenty of money on hand now but wish to keep your future expenses low. In that case, you might choose the VA loan with the lowest interest rate — even if its APR is a bit higher than the others — to minimize your monthly payments, even if it means paying more on closing.
Or you may have other considerations. For example, you may wish to work with a lender with a stellar reputation for customer service. This could sway you toward a loan with a slightly higher interest rate and APR if it will make your home buying or refinance process go more smoothly.
So take a step back and consider your priorities. If it turns out you want the lowest total cost of borrowing, go with the lowest APR.
Interest rate & APR: Why two numbers?
By now you know why lenders have to provide two numbers: the interest rate and the APR. They both tell you different things and each is useful in its own way.
With a VA loan, the interest rate will give you a sense of how high your monthly payments will be. Interest rates won’t be quite as useful for other mortgages that have continuing mortgage insurance.
An APR gives you a good idea of how much the total cost of borrowing will be for your VA loan. If an APR is much higher than the interest rate, you can be sure the associated borrowing costs are high.
Do take time to study your quote (called a ‘loan estimate’) carefully. Federal regulator the Consumer Financial Protection Bureau has a great online guide on what to look for and why. In particular, look out for the first section on page 3, which includes information about the APR in a standardized format that’s easy to compare against other loan quotes.
Loan estimates are standardized so you can readily compare them side by side. You’ll be able to use both the quoted interest rate and APR to determine which VA loan suits you best.