Interest Rate and APR: What’s the Difference?
The interest rate is the cost you pay to borrow money, expressed as a percentage of the loan amount. It determines your monthly principal and interest payment, but it’s not the only number to watch.
APR, or annual percentage rate, includes the interest rate plus certain lender fees and closing costs, so it reflects the total annual cost of the loan. Comparing APRs can help you see the true cost of different mortgage offers, but the exact fees included vary by lender.
When shopping for a mortgage, look at both the interest rate and the APR. The interest rate tells you your monthly payment, while the APR gives you a broader picture of the loan’s cost over time.
- Interest rate: the basic rate used to calculate your monthly payment.
- APR: interest rate plus lender fees and points, expressed as a yearly rate.
- Lenders may quote different APRs for the same interest rate, depending on fees.
Fixed-Rate and Adjustable-Rate (ARM) Terms
A fixed-rate mortgage has an interest rate that stays the same for the entire loan term, making monthly principal and interest payments predictable over 15, 20, or 30 years.
An adjustable-rate mortgage (ARM) has an interest rate that changes periodically. ARMs typically have an initial fixed-rate period—such as 5, 7, or 10 years—after which the rate adjusts based on a benchmark index plus a margin. Common terms you’ll see include the initial adjustment period, adjustment frequency, and rate caps that limit how much the rate can change at each adjustment and over the life of the loan.
Some ARMs come with a convertible feature, allowing you to switch to a fixed-rate loan during a specified window. Rate caps protect borrowers from extreme increases, but the specific caps and adjustment intervals vary by lender and loan program.
- Fixed-rate: rate stays constant; payment stability.
- ARM: initial fixed period, then rate adjusts periodically.
- Rate caps: maximum interest rate change per adjustment and over the loan term.
- Index and margin: the basis for rate adjustments.
Points and Origination Fees
Discount points are optional fees you can pay at closing to lower your interest rate. One point typically equals 1% of the loan amount. For example, on a $200,000 loan, one point costs $2,000 and might reduce your rate by a set amount, but the exact reduction depends on the lender and current market conditions.
Origination fees are charged by the lender for processing the loan application and underwriting. They may be a flat fee or a percentage of the loan amount. Both points and origination fees affect your APR, because they are added to the total cost of the loan.
When deciding whether to pay points, consider how long you plan to stay in the home. Paying points can lower your monthly payment, but you’ll need to stay long enough to recover the upfront cost. Use the same formula lenders use to calculate your break-even point, but you can also use an online mortgage calculator or ask your lender for the exact savings.
- Discount points: prepaid interest that lowers your rate.
- Origination fee: lender’s charge for processing the loan.
- Points and fees increase your APR.
- Break-even: the time it takes to recover the cost of points through lower monthly payments.
Rate Lock and Float-Down
A rate lock is a lender’s guarantee that you’ll receive a specific interest rate for a set period, usually 30 to 60 days. Locking in a rate protects you if market rates rise, but if rates fall before closing, you’re stuck with the locked rate unless you have a float-down option.
A float-down is an option that allows you to lock in a lower rate if market rates drop after you’ve locked. This option usually comes with a fee and specific conditions, such as the rate must drop by a certain amount, and it’s not offered by all lenders.
Standard rate lock periods are typically 30, 45, or 60 days. Longer locks may cost more, and some lenders allow you to extend a lock for a fee. Always ask about the lock period, float-down availability, and any associated costs before committing.
- Rate lock: guaranteed rate for a set time.
- Float-down: lets you drop your rate if market rates fall.
- Typical lock periods: 30, 45, or 60 days.
- Float-down may require a fee and specific conditions.
Loan-to-Value (LTV) and Credit Score Basics
Loan-to-value (LTV) ratio is the size of your mortgage compared to the appraised value or purchase price of the home, expressed as a percentage. For example, if you put down 20% on a $300,000 home, your loan amount is $240,000, so your LTV is 80%. Lenders use LTV to assess risk: higher LTV ratios often mean higher rates or stricter requirements, and you may need to pay private mortgage insurance if your LTV is above 80%.
Your credit score is a numerical measure of your creditworthiness, based on your borrowing and payment history. Lenders use it to decide whether to approve you and at what interest rate. Higher credit scores generally qualify for lower rates, while lower scores may lead to higher rates or require a co-signer.
Understanding your LTV and credit score helps you anticipate the rate and terms a lender may offer. You can request your credit report and score from the three major credit bureaus, and you can calculate your LTV using your estimated home value and down payment.
- LTV: loan amount ÷ home value × 100.
- Higher LTV often means higher risk.
- Credit score: a snapshot of your credit history.
- Both LTV and credit score influence your rate.
Related Terms: PMI, Escrow, Amortization
Private mortgage insurance (PMI) is insurance that protects the lender if you default on your loan. It’s typically required when your down payment is less than 20%, or your LTV is above 80%. PMI adds to your monthly payment, but you may be able to cancel it once your LTV reaches 80%.
Escrow is an account held by your lender to pay property taxes and homeowners insurance on your behalf. A portion of your monthly payment goes into escrow, and your lender uses those funds to pay the bills when they’re due. This ensures you don’t face large lump-sum payments.
Amortization is the process of paying off your loan over time through regular payments. With a fixed-rate mortgage, you make equal monthly payments, but the split between interest and principal changes over time: early payments go mostly to interest, later payments go mostly to principal. An amortization schedule shows how each payment is applied and how your loan balance decreases.
- PMI: insurance required when LTV > 80%.
- Escrow: lender-managed account for taxes and insurance.
- Amortization: gradual payoff of principal and interest over the loan term.
Frequently asked questions
What is APR and how is it different from the interest rate?
The interest rate is the basic cost of borrowing, used to calculate your monthly payment. APR (annual percentage rate) includes the interest rate plus certain lender fees and points, so it reflects the total annual cost of the loan. For example, a 6.5% interest rate with fees might result in a 6.7% APR. When comparing loans, look at both: the interest rate for your payment, the APR for the overall cost.
What does 'discount points' mean?
Discount points, also called points, are upfront fees you pay to lower your interest rate. One point typically equals 1% of your loan amount. For instance, one point on a $200,000 loan costs $2,000 and might reduce your rate by 0.25%. The exact rate reduction varies by lender and market conditions. Points raise your APR because you’re paying extra at closing, but they can lower your monthly payment over time.
How long can I lock in a rate?
A rate lock typically lasts 30 to 60 days, but you may be able to lock for longer, sometimes up to 90 days or more, often for a fee. The lock period should cover the time needed to process your loan. If rates fall after you lock, a float-down option might allow you to get a lower rate, but it usually comes with a fee and conditions. Ask your lender for the specific lock terms and costs.
What is PMI and when is it required?
Private mortgage insurance (PMI) protects the lender if you stop making payments. It’s typically required when your down payment is less than 20%, meaning your loan-to-value ratio is above 80%. PMI adds to your monthly mortgage payment. You can request cancellation once your LTV reaches 80%, and some loans automatically terminate PMI when you reach 78% LTV, based on the original value.
What is loan-to-value ratio?
Loan-to-value (LTV) ratio is your mortgage balance divided by the home’s appraised value or purchase price, expressed as a percentage. For example, a $240,000 loan on a $300,000 home gives an LTV of 80%. Lenders use LTV to assess risk: high LTV ratios (above 80%) may require PMI and can lead to less favorable terms. Lower LTVs, such as 80% or below, often qualify for better rates.