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

Keith Gumbinger

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 actually 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 4.168%, 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!

In addition, while stated APRs are based on the original loan term, most mortgages never make it to the full term. In these cases, the impact of paying fees becomes more pronounced, since the actual term of the loan before refinancing or pay off is shorter. The above APR example uses a 30-year term; however, if the borrower's actual term ends up being shorter (from refinancing or paying off the loan), the loan's effective APR increases. How much it will increase depends on the final actual loan term.

Different ways of paying mortgage closing costs will affect the loan's APR, too, since certain choices can have an effect on the size of the loan or the contract interest rate.

The APR calculation is far more complicated for ARMs, and doesn't properly account for today's products where the initial interest rate may be higher than even the calculation of the ARM's index value + margin, the sum of which produces the loan's future interest rate. In an ARM, since the loan's contact interest rate will change in the future, the stated APR at the time the loan is closed will only be accurate during any fixed-rate period -- after that, there's no way to know what it actually will be, since that will depend on future and unknowable interest rate 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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