According to recent housing data, the average home value in the United States in 2019 was $231,000. Since most people don’t have that much money available, they rely on a mortgage to buy a home. A mortgage is a loan that allows you to borrow money and pay it back over a longer period while also paying interest, or the cost of the loan.
To make informed financial decisions, you need to understand the terms of your mortgage. When discussing a mortgage, you may have heard words like "interest rates" and "APR”.
This guide explains everything you need to know about the difference between a regular mortgage interest rate and APR, including how they're calculated and how they affect your mortgage.
What is a mortgage interest rate?
The interest rate is the annual cost you pay to take out a loan, and it's expressed as a percentage. For example, a 4% interest rate means you'll pay 4% of your loan's total balance in interest each year. Your loan's principal balance decreases as you pay it down, and the amount of interest you need to pay each month goes down as well.
A mortgage interest rate can be fixed or variable. A fixed interest rate is the same rate over the life of the loan. A variable rate can change over time.
The interest rate a lender charges depends on market factors and on your financial situation. Things such as your credit score and payment history, income, assets, debts and other considerations—like occupancy and property type—may affect the interest rate a lender will offer you.
Generally, the greater risk a borrower poses to lenders, the higher their interest rate. Different lenders might also offer different rates, so it's important to shop around before choosing a bank or a broker.
What is APR?
The annual percentage rate, or APR, captures the cost of borrowing money beyond the interest rate. APR includes the interest rate, as well as any mortgage broker fees, points or other charges you pay on a loan. The APR is, therefore, usually higher than the interest rate. The APR provides you with the big picture of the cost of a loan over its lifetime expressed as an annual rate.
Potential borrowers should use both the regular interest rate and APR to comparison shop between lenders to determine whether a loan is truly affordable. The Truth in Lending Act requires lenders to disclose a loan's APR. When shopping around to compare loans, you should receive a Loan Estimate from one or more lenders. You can find the interest rate in the loan terms section and the APR in the comparisons section of the Loan Estimate.
How to get the best mortgage interest rate
You can take a number of steps to make sure you're getting the best rate on your mortgage:
- Improve your credit score. A credit score summarizes your borrowing history and a lender's risk in lending to you. Lenders use your credit score to determine whether to offer you a loan, as well as to calculate your interest rate. Improving your credit score may help you qualify for better interest rates and terms when applying for a new mortgage, or refinancing one.
- Build a record of employment. Lenders like to see that a potential borrower has at least two years of steady income. You'll need to show your W-2s and pay stubs when you apply for a loan. This can be more complicated if you have an uneven employment history, are self-employed or have multiple income sources.
- Save up for a larger down payment. Putting at least 20% down will lower your payment as well as avoid private mortgage insurance for most loans which typically equals 1% of the original loan amount each year.
- Shop among lenders. Make sure you've explored all your options. In addition to talking to your local bank or credit union, explore online options and mortgage brokers. Compare the Loan Estimates you receive to determine which one is best for you.
- Lock in your interest rate. Even after your offer on a home has been accepted, it can take several weeks to close. In that time, interest rates could change. You can ask your lender to lock in your rate after you've secured a loan to avoid your interest rate rising before you close.
You have a number of factors to consider when deciding whether to buy a home, how much you can afford and how to get a loan. Understanding the difference between a regular mortgage interest rate and an APR will help you take the next step in your homebuying journey.