Understanding Mortgage APR and Interest Rate

by Gary Foreman

There is a difference between your mortgage APR and the interest rate. An understanding of these two important numbers can help you pay down your mortgage faster and save on interest.

Dear Dollar Stretcher,
Most of us have at least one mortgage these days, but there is so much confusion over the interest. It seems that by the time you’ve paid off your mortgage, the interest costs more than your home. I would love to know how the interest is calculated and how it can end up being way more than the home. Also what is the difference between your APR and your interest rate? Please help.
Jennifer in NC

Like so many people, Jennifer was surprised when she got past the “easy monthly payment” and started learning about mortgages. Let’s see if we can’t help her to understand the basics of mortgage APR (annual percentage rate) and interest rate.

The definitions of APR and interest rate

We’ll start with definitions for each term from Investopedia. Interest rate “is the amount a lender charges a borrower and is a percentage of the principal— the amount loaned. The interest rate on a loan is typically noted on an annual basis known as the annual percentage rate.”

Annual Percentage Rate (APR) “refers to the yearly interest generated by a sum that’s charged to borrowers or paid to investors. APR is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan or income earned on an investment. “

What you need to know about APR and interest rates to save money on mortgage interest

Let’s first examine the definition for interest rate. Simply put, it’s a rate that the borrower pays for using the lender’s money. Just like you would pay to rent a car or a punch bowl for a wedding, you pay to rent money.

Interest is typically stated as a percent of the amount owed that’s due every year of the loan. A real simple example would be if I borrowed $100 from you and agreed to pay you back one year from today along with 8% interest. When the year was up I’d need to give you $108 (the original $100 plus $8 interest).

Next we’ll examine how the frequency of compounding effects the real cost of borrowing. In our example, the interest was compounded once a year. But what would happen if we compounded it twice a year? At the end of the year, I would need to pay you $108.16.

Why sixteen cents more than the original example? I’d still have to pay back the same $100 principal, but because the interest is compounded twice each year, we’d need to calculate and add two separate interest payments. For the first six months, I’d owe $4 ($100 principal multiplied by 8% annual interest divided by two equals 4%).

But for the next six months, I’d owe $4.16. Because interest was owed (and unpaid) after the first six months, the principal amount was increased by $4 to $104. And 4% (half of 8%) of $104 is $4.16. So over the entire year, I’d owe $8.16 for interest ($4 first six months plus $4.16 for the second six months).

If we were to compound daily, the total due at the end of a year would be $108.33. So even though the interest rate stays the same (8%), the amount that you’ll pay could vary by $0.33 depending on how often interest is compounded. Not a tremendous amount, but it does add up when you’re borrowing hundreds of thousands of dollars. (See also: The 10 Things You Need to Know About Compound Interest.)

The APR will include any additional costs caused by frequent compounding. When it’s used in a mortgage situation, it also includes mortgage insurance and any “points” that came with the mortgage.

For most of us, it’s almost impossible to calculate how much we’d owe on a mortgage with all the different variables involved. The APR does that for us. We can take two mortgages and compare the APR on each. You can also use the APR to compare non-mortgage consumer loans.

Related: How We Saved $34k in Interest on Our Mortgage Before Closing

A look at the mortgage interest you can expect to pay

Next let’s look at all the interest that Jennifer expects to pay. She’s right. A traditional 30-year mortgage earns a lot of interest for the lender. To illustrate, we turned to a mortgage calculator. For a 30-year, $200,000 mortgage at 4.5% you’ll pay $164,814 in interest over the life of the mortgage. Just as Jennifer said, it seems like you’re paying more in interest than you originally borrowed.

One solution for Jennifer is to go to a shorter mortgage. A 15-year mortgage (the same $200,000 at 4.5%) would require $75,397 in interest payments. That’s a huge difference. The downside is that Jennifer will need to handle a higher monthly payment ($1,013 vs. $1.530).

The higher payments might scare Jennifer. But she still has an option that will reduce interest expense. As long as her mortgage allows for prepayments, she can pay more than the regular payment each month. Have the lender apply the extra money to a reduction in principal. Depending on how much she prepays each month, it could be just as effective as a 15-year mortgage in reducing the amount of interest paid.

Hopefully Jennifer will find both the home and the mortgage that she loves and can afford.

Related:

• Managing Your Mortgage for Building Wealth
• 5 Ways To Save on Your Mortgage
• Should You Refinance Your Mortgage?

Reviewed July 2023

About the Author

Gary Foreman is the former owner and editor of The Dollar Stretcher. He's the author of How to Conquer Debt No Matter How Much You Have and has been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.