There is a difference between the interest rate and APR (annual percentage rate.) It is confusing when you start looking at rates from different lenders because each lender may present the rate differently. How do you shop for the best rate if they are different? When comparing loan offers from multiple lenders, it can be helpful to look at the Total Interest Percentage (TIP), which is the amount that you would pay in interest over the life of a loan
The Difference Between the Interest Rate and APR Explained
The interest rate is the annual cost of borrowing money to buy a house, but it doesn’t reflect the total cost of a mortgage. The annual percentage rate
(APR) includes lender fees and other charges and indicates the total cost to borrow money over the term of the mortgage. The Total Interest Percentage, or TIP, on the other hand, doesn’t take upfront fees into account, except prepaid interest, if you choose that.
The interest rate and annual percentage rate are based on a one-year period. The TIP is usually much larger since it reflects the amount of interest you would pay over the entire term of a loan.
While the interest rate determines the cost of borrowing money, the APR is a more accurate picture of total borrowing cost because it takes into consideration other costs associated with procuring a loan, particularly a mortgage.
When you’re shopping for a home loan, you’ll see lenders advertise their best mortgage interest rate vs. APR, or annual percentage rate. They’re required to show you both rates, because APR gives you a sense of the lender’s fees in addition to the interest rate. As a borrower, you need to know if a lender is making up for a low advertised interest rate with high fees, and that’s what the APR can tell you. If the APR is close to the interest rate, you’ll know that the lender’s fees are low.
Total Interest Percentage
The total interest payment or TIP can be found in your Loan Estimate or Closing Disclosure. The figure is calculated by adding up all scheduled interest payments and dividing by the amount borrowed to arrive at a percentage. For example, if you took out a mortgage for $200,000 and your interest payments over the life of the loan would total $100,000, the Total Interest Percentage would be 50 percent, since the sum of all the interest payments would be half of the amount borrowed.
How Important is the TIP?
The TIP calculation assumes that you will keep a mortgage for the entire term and make all payments as scheduled. If you’re planning to purchase a home and live there for the rest of your life, the TIP will be important. If you’re comparing the terms of 30-year mortgages but you think you’ll probably sell your house much sooner than that, the TIP may not be as relevant to you.
Other factors could affect the total amount you would pay in interest. If you made extra payments toward the principal, you would pay off the loan sooner and pay less in interest. You might also refinance and get a lower interest rate.
If you requested a Loan Estimate for a mortgage with an adjustable rate, the TIP will be calculated based on current interest rates. The actual amount you would pay in interest and the actual TIP could vary significantly due to future rate changes.
When you are trying to understand the difference between the interest rate and APR, you want to look at the TIP also.
How Long Will You Own Your Home?
When you request mortgage quotes, you will be given several pieces of information. If you plan to stay in a house long-term, the total amount you will pay in interest can be important to consider. If you only expect to live in a house for a relatively short amount of time, the TIP may not be as much of a factor for you. If you have any questions, talk to your real estate agent. If you want to start looking for a new home, you can start your search right here.
Using APR to Compare Mortgage Offers
Comparing APRs is not the best way to evaluate mortgage offers. Instead, it’s more useful as a regulatory tool to protect consumers against misleading advertising.
Federal Regulation Z, the Truth in Lending Act, requires lenders to disclose a loan’s APR when they advertise its interest rate. As a result, when you’re checking out lenders’ websites to see who might give you the best interest rate, you’ll be able to tell from looking at the APR if the lender with the great interest rate is going to charge you a bunch of fees, making the deal not so great after all.
Page 3 of the loan estimate that lenders are required to give you when you apply for a mortgage shows the loan’s APR. By comparing loan estimates (mortgage offers), you can easily compare APRs.
Still, most borrowers shouldn’t use APRs as a comparison tool because most of us don’t get a single mortgage and keep it until it’s paid off. Instead, we sell or refinance our homes every few years and end up with a different mortgage.
If you’re looking at two loans and one has a lower interest rate but higher fees, and the other has a higher interest rate but lower fees, you might discover that the loan with the higher APR is actually less expensive if you’re keeping the loan for a shorter term.
You’ll need to use a calculator and do the math on the actual offers lenders are giving you to make this comparison for your own situation and see which offer benefits you the most, given how long you expect to keep your loan. Keep in mind that economic and life circumstances can change, and you might not end up moving or refinancing in a few years even if that’s your plan now.