As you move through the home buying process you’ll likely encounter a variety of words and definitions that you’re unfamiliar with. Two commonly misunderstood terms, APR and interest rate, will undoubtedly have an impact on how much you pay for your mortgage, so understanding what they mean and how they differ is vital. While they refer to similar concepts, they have subtle differences when it comes to calculation that you’ll want to be aware of in advance.
What Is Interest Rate?
The interest rate, sometimes referred to as a nominal rate, is the cost of borrowing the principal loan amount. This rate can be variable or fixed depending on your mortgage, but it’s always expressed as a percentage. As you make mortgage payments on your principal balance, the interest rates and monthly payments will remain the same but a smaller portion will be put toward interest as time goes on, meaning more will go toward your principal which increases your equity.
How Interest Rates Are Determined
Interest rates are determined by market trends and can be influenced by the policy of the Bank of Canada, the demand for loans, the supply of available lending capital, interest rates in the United States, inflation rates and other economic factors. This means they are ever-changing and important to watch.
The interest rate you get on a mortgage will also depend on your personal finances. Lenders will look at your credit score which, unlike market trends and outside influences, you can actually control.
What Is APR?
Arguably the most effective rate to consider when comparing loans, APR stands for Annual Percentage Rate. Almost always higher than the interest rate, the APR includes other costs associated with borrowing the money for a mortgage such as broker fees, rebates and closing costs.
It’s important to keep in mind that APR does have some caveats to consider:
– It lacks the effectiveness to calculate the true cost of an adjustable-rate mortgage because it’s impossible to predict future interest rates.
– It can make your mortgage more expensive should you choose to refinance or sell your home because the calculated servicing costs are spread out over your entire amortization period, which can be as long as 30 years.
How APR Is Determined
Unlike interest rates, the APR is set by individual lenders and they choose how much they want to charge for additional fees on top of the interest rate. For example, some lenders may charge different amounts for closing fees so even though they offer the same interest rates, their APRs might actually be different.
It’s important to note that lenders may not include all fees in the APR (like credit reporting, appraisal and inspection fees). When you’re shopping for a loan, be sure to ask your lender what is, and is not, included so you can get the most accurate comparison possible.
How APR And Interest Rates Factor Into Your Mortgage
When you’re looking for a mortgage, the APR and interest rate are two of the most important numbers to consider. Even a small difference in rates can have a significant impact on your total costs so don’t underestimate their importance as part of the process. To keep things simple, think of the interest rate as a way to gauge your monthly costs, whereas the APR gives you a big-picture estimate of the cost of the loan.
It’s likely that you may get confused when you notice two different lenders are offering the same nominal rate and monthly payments but different APRs. For example, you may talk to one lender and see that your interest rate is 3% but your APR is 3.25%. You speak to another lender and your interest rate is 3% but your APR is 3.175%. In a case like that, the lender with the lower APR is requiring fewer fees and therefore offering a better deal overall. Just make sure that you are comparing apples to apples when looking at loan products.
How long you plan to stay in your home will also impact how you use and compare these numbers as part of the home buying process. If you’re on the hunt for your forever home, shopping around and choosing a mortgage with the lowest APR and upfront fees is always a smart decision as you’ll pay less in the long run. If you don’t plan on staying in this home long term, it may make more sense to choose a loan with a higher rate, fewer upfront fees and a higher APR, so you’ll end up paying less during the first few years of the mortgage.
While the interest rate determines your cost of borrowing money, the APR is a more accurate picture of total borrowing cost because it takes into account the bigger picture of borrowing money and all the extra costs that come along with it. Pay attention to both numbers when applying to borrow money but understand how they differ so you can make the best strategic decision for your personal situation. Want to learn more about the home buying process or applying for loans? Reach out to our team to get the conversation started!