What is the difference between "rate" and "APR"?

Q: What is the difference between "rate" and "APR"?

A: APR (Annual Percentage Rate) is perhaps the most misunderstood part of mortgage finance. "Rate", or more properly "contract interest rate" is the actual rate of interest you are being charged. If it costs you nothing to get your loan -- that is, there are absolutely no costs whatsoever -- your interest rate and APR would be identical. However, mortgage loans do have fees, and paying them means that your actual cost of credit is higher.

Here's why: If you want to borrow $100,000 at 4%, your contract will say 4%, and your monthly payment on a 30-year term will be $477.41 per month. If there are no costs at all to obtain the loan, your APR will be 4.00%

However, if it cost you $2,000 to get the loan, you didn't actual net $100,000 from the mortgage lender, but rather $98,000 instead. Your monthly payment, by contract, is still $477.41 - and making a $477.41 per month payment on a $98,000 loan translates into an interest rate of 4.16%, which is your actual cost of the loan -- and your APR.

Please know this is a simplified example. What does or does not get included in the calculation of APR is affected by lender refund policies and more. As such, it's possible for two seemingly identical loans to have different APRs!

The calculation is far more complicated for ARMs, and doesn't properly account for today's products where the initial interest rate is higher than even the calculation of the sum of index + margin, which governs the interest rates for future loan changes.

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Keith Gumbinger
Keith Gumbinger
Mortgage Expert
Vice President, HSH.com
About Keith: Mortgage market observer and analyst with 35 years experience... (more)
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