The interest rate, also referred to as the mortgage interest rate, and APR are both super important for getting a clear picture of the cost of a loan, but they do different things. Your interest rate is just one portion of the cost, but your APR is a more holistic representation of the full ticket price, inclusive of all those extra fees outside of the baseline mortgage payment. Here’s a quick chart to help you understand what each term really means and how they affect your loan:

When you have a mortgage, you pay a fee to borrow funds. Simply put, the interest rate is the cost you pay annually to borrow money, expressed as a percentage. This rate is what you'll see advertised by banks and lending groups as the headline figure for loans and mortgages.

Interest rates in action

Scenario: You take out a $300,000 mortgage at with an interest rate of 4.00% per year to be paid over 30 years. The interest rate is fixed and will not change over the 30-year term of the loan.

Monthly payments: To find out your monthly principal & interest payment, you can use the formula for a fixed-rate mortgage. This calculation tells us that your monthly payment would be approximately $1,432.

How payments are split: In the first month, your payment is divided into interest and principal. The interest for the first month is calculated as 4.00% of $300,000, divided by 12 months, which equals about $1,000. So, of your $1,432 payment, $1,000 goes towards interest, and the remaining $432 reduces your principal.

Subsequent payments: In the second month, your new principal is $299,568 ($300,000 - $432). The interest for this month is calculated on the new principal, which would be slightly less than the first month's interest. Therefore, a slightly larger portion of your second payment goes toward reducing the principal. This process continues each month, gradually decreasing the interest portion and increasing the principal portion of your payment.

Long-term impact: Over time, as you continue to pay down the principal, the interest collected each month decreases, proportionate to the rate at which the principal is paid off. This is often referred to as an amortization schedule.

This example reflects a typical mortgage payment structure where each payment covers interest owed for the period and reduces a portion of the principal, leading to full repayment of the loan by the end of the term.

The annual percentage rate is a measure of the cost of credit, expressed as a yearly rate. So, it goes a step further than the interest rate by including costs of a home loan, such as mortgage insurance, discount points, loan origination fees and other loan related charges. The APR is also expressed as a percentage and provides a more comprehensive look at the cost of a loan.

When you're looking at loans, a low interest rate might catch your eye and seem like the best deal. But let's take a closer look—there's more to the story with the APR.

Imagine you have two loan options:

• Loan A has a lower interest rate but comes with higher fees.
• Loan B has a higher interest rate but lower fees.

At first glance, Loan A might look more appealing because of its lower interest rate. However, if we dive into the APR, which includes all the fees, you might find that Loan B is actually the better deal in the long run. The APR gives you a fuller picture by showing the total cost of the loan, not just the interest rate.

Let’s take a look at the main factors that influence interest rates. Remember, interest rates are always on the move, so it's normal to see them go up and down.

1. Credit score: Sporting a high credit score can unlock lower interest rates, signaling to lenders that you're a safe bet for timely repayments.
2. Loan amount and loan term: Sometimes the interest rate for a loan will differ depending on the loan size and the loan term.
3. Current market conditions: Inflation and economic growth play a starring role in setting interest rates and affect whether they trend up or down.
4. Federal reserve rates: The rate set by the Federal Reserve, commonly known as the fed funds rate, reflects current market conditions and can forecast market conditions. Changes in the fed funds rate influence the prime interest rate, which can affect consumer products including mortgages, Home Equity Lines of Credit (HELOCs) and credit cards.
5. Fixed vs. variable rates: Interest rates come in two flavors: fixed and variable. A fixed rate mortgage does not experience changes in the interest rate during the term of the loan. On the other hand, a variable rate loan, referred to as an adjustable rate mortgage, can change over time. This means your interest rate can go up or down based on the specific index it’s tied to, like the Secured Overnight Financing Rate (SOFR). To prevent these rates from changing too drastically, variable rate loans have caps that limit how much the interest rate can increase or decrease. In addition, some variable rate loans offer a period where the rate stays fixed before it starts to vary, giving you some initial stability.

It's important to note that these are not the only factors that determine interest rates. Other elements such as the type of loan, the state and type of property, the purpose of the loan and the loan-to-value ratio also play critical roles. Understanding that a variety of factors can influence the rate will provide a more comprehensive view of how interest rates are calculated.

The APR is calculated by combining the interest rate with other costs, such as loan related closing costs or private mortgage insurance, and expressing that as a yearly rate. The Truth in Lending Act requires lenders to disclose the APR, ensuring transparency so you can make an informed decision when comparing similar loan programs. While the formula for calculating APR can be complex, the key takeaway is that APR offers a more comprehensive and uniform estimate of loan costs.

Typically, home buyers are on the hunt for the lowest interest rate they can find to snag the most affordable monthly payments. There are a few ways you can increase your chances of locking in a lower rate, from having a great credit score to qualifying for special loans that promise certain rates.

Raise your credit score

Boosting your credit score is arguably the most direct way to influence the interest rates available to you. A higher credit score indicates to lenders that you pose a lower risk, which can translate into more favorable interest rates.

Get a government-backed loan

Borrowers with lower FICO scores or a lower down payment may find that government backed loans, like FHA or VA loans, have lower interest rates available compared to conventional loans. These loans are insured by government agencies, meaning the lenders can offer lower rates because they’re taking on less risk.

Buy down the rate

The interest rate can be lowered by paying discount points. Mortgage points are a fee, generally 1% of the loan amount, that lowers the interest rate. The lower rate applies to the life of your fixed rate loan.

Increase your down payment

Upping your down payment can help lower your loan-to-value (LTV) ratio which is just a fancy way of saying the percentage of your home's value that's covered by your loan shrinks. A lower LTV may mean you can snag a lower interest rate. So, putting down more upfront can pay off with smaller interest payments down the line.

Leverage relationship pricing programs

Some lenders, like Citi, offer special pricing programs for existing customers. For example, Citi’s Mortgage Relationship Pricing program offers closing cost discounts or a discount on the interest rate for new and existing Citi banking customers based on their Citi Eligible Balances.

Getting a handle on the difference between APR and interest rate can be a game-changer in finding the best deal on your home purchase. While the interest rate shows the basic cost of borrowing the principal amount, the APR includes the interest rate plus all the additional fees or costs tied to the loan. This gives you a clearer picture of the total cost of borrowing. Understanding this distinction ensures that you're not just snagging a low rate, but also securing the most favorable overall terms for your mortgage.