It is important to know how the APR (or annual percentage rate) compares with the interest rate that you will pay on your mortgage. The interest rate is how much you'll pay to borrow money for your home. This rate does NOT reflect any fees or other charges, but it calculates your monthly mortgage payment. Your credit score and loan type will impact the interest rate that you pay.

However, the annual percentage rate reflects the true cost of the loan. The annual percentage rate includes the interest rate and any upfront costs or fees charged by the lender in order to get that rate or close the loan.

The advertised annual percentage rate is usually displayed next to the nominal interest rate. It is also known as "APR," or nominal interest rate. This annualized fee and cost associated with loans make it higher than the effective or actual loan interest rate. The APR represents the return to maturity of all finance charges that the borrower has paid. It also provides an accurate picture of the annual cost of your loan.

Understanding Your Annual Percentage Rate

The annual percentage rate is a useful tool to compare loans between lenders and potentially save you thousands of dollars. Even if different lenders are advertising the same interest rate, of say 4.5 percent, the APR of one might be 4.85 percent and of another 5.1 percent - simply because it has higher fees and closing costs to obtain that loan. Another option is to offer a higher interest rate but with lower associated costs. This could make it a better loan than one that has a lower advertised rate and higher associated costs.

The APR is a measure of how much you will pay over the life of the loan. The APR will likely be higher if you pay less in closing costs. However, closing fees will make it more affordable.

What is Covered?

Fees and costs that may be bundled into the annual percentage rate are the origination fee, discount points, closing costs and the cost of mortgage insurance premiums. These fees are sometimes referred to as finance charges. However, there may be additional fees that contribute to the APR.

If you pay your property taxes or homeowners insurance through your lender because the payments are held in escrow, these are not part of the annual percentage rate because these are not charges being billed to you by the lender. These payments are collected by the lender on behalf of the county or agency.

Actual vs. Advertised

Although you may see a great advertised annual percentage rate, your actual annual rate is not determined until your loan is vetted with the lender’s underwriter. This is because the lender might charge higher fees for someone with a lower credit score than someone with near-perfect credit. They’ll have to run a credit report to see what your actual credit score is. Typically, the higher your credit score, the lower your interest rate. Learn more about credit scores here.

Your estimated APR is disclosed to you through a Truth in Lending document known as TILA. This APR is considered final once you have locked in your interest rate.

A Higher Rate Might Be Better

Sometimes a loan with an annual percentage rate higher than the one with a lower APR will be more affordable.

You might consider this option if you are offered the opportunity to pay the closing costs but not roll them into your purchase price, as a high APR usually has a lower interest rate.

Let's say that you offer $310,000 for a $335,000 home, and the seller agrees with your closing costs. You might find a loan with a lower interest rate and higher APR, which is money that the seller will pay at the closing, more advantageous than one with a higher rate and lower APR.

Regulations

The federal government requires all lenders to inform consumers about the annual percentage rate in order to protect the consumer. This is done through the Truth in Lending Act (TILA).

TILA makes sure that credit terms are clearly disclosed so consumers can compare credit terms and make informed decisions about the best loan option for them.

Consumers used to have difficulty comparing loans before TILA was enacted. This was because the loan documents were not presented in the exact same format. Consumers can now compare the annual percentage rates to see how creditors use credit terminology. Consumers should look at an itemized listing of fees that are included in the APR for the best comparison. One lender might include courier fees, while another may not.

Your annual rate may also differ if you apply for a primary mortgage, refinance or take out a loan to purchase an investment property. You might have a different annual rate if you get a fixed-rate or adjustable-rate loan. This is because the federal government regulates these loans differently.