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

You'll see an interest rate and an Annual Percentage Rate (APR) for each mortgage loan advertised. The easy answer to "why" there are two rates is that federal law requires the lender to disclose both.

The APR is a tool used for comparing different loans – which will include different interest rates, but also different points and other terms. The APR is designed to represent the "true cost of a loan" to the borrower, expressed in the form of a yearly rate. Because the APR is disclosed, lenders cannot "hide" fees and upfront costs behind low advertised rates.

While it's designed to make it easier to compare loans, it's sometimes confusing because the APR includes some, but not all, of the various fees and insurance premiums that accompany a mortgage. And since the federal law that requires lenders to disclose the APR does not clearly define what goes into the calculation, APRs can vary from lender to lender and loan to loan.

The APR on a loan tied to a market index, like a 5/1 ARM, assumes the market index will never change. But ARMs were invented because the market index fluctuates and makes fixed rate loans cheaper or more expensive to make – that's why they're called variable rates.

So, APRs are at best inexact. The lesson is that the APR can be a guide, but you need a mortgage professional to help you find the right loan for you.

Note when you're browsing for loan terms that the APR will not tell you about possibilities such as balloon payments or prepayment penalties or how long your rate is locked. Also, you'll see that APRs on 15-year loans will carry a higher relative rate due to the fact that points are amortized over a shorter period of time.

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