In short: The interest rate sets your payment. The APR tells you what the loan costs once the lender's fees are counted. A $300,000 mortgage at 6.5% with $6,000 of fees has a payment of $1,896.20 either way, but an APR of 6.695%. The catch is that APR assumes you keep the loan for its full term. Sell or refinance after five years and those same fees make the real cost 6.99%.
What each number measures
The interest rate, sometimes called the note rate, is the rate charged on the balance. It alone determines the monthly payment of principal and interest.
The annual percentage rate is a single rate that folds the lender's upfront charges into the cost of borrowing. It answers a different question: taking the fees into account, what rate am I effectively paying?
On a loan with no fees at all, the two are identical. Every dollar of finance charge pushes the APR above the interest rate.
How fees turn into a higher rate
The idea is simple once it is stated as cash. If you borrow $300,000 and pay $6,000 in fees at closing, you walk away with $294,000 of usable money. But your payments are still calculated on $300,000.
So you are repaying a $300,000 loan while having received $294,000. The APR is the interest rate that would produce those same payments on a $294,000 loan.
For 360 payments of $1,896.20 on $294,000 received, that rate is 6.695%. The loan's stated rate is still 6.5%. The 0.195 percentage points between them is the fee, expressed as a rate.
The same loan with different fees
All three loans below are $300,000 at 6.5% over 30 years, with an identical payment of $1,896.20.
| Finance charges at closing | Amount effectively received | APR |
|---|---|---|
| $3,000 | $297,000 | 6.597% |
| $6,000 | $294,000 | 6.695% |
| $9,000 | $291,000 | 6.795% |
Each additional $3,000 of fees adds roughly a tenth of a percentage point. This is what makes APR useful: two offers with the same rate and different fees get different APRs, and the lower one is cheaper over the full term.
The assumption hidden inside APR
APR spreads the fees across the entire scheduled life of the loan. On a 30-year mortgage, that means across 360 months.
Most mortgages do not last 360 months. They end when the home is sold or the loan is refinanced. When that happens the fees have already been paid in full, but they have been spread over far fewer months than the APR assumed, so the true annual cost was higher.
Here is the same $300,000 loan at 6.5% with $6,000 of fees, with the real cost calculated for different holding periods:
| Loan kept for | Effective annual cost |
|---|---|
| 3 years | 7.256% |
| 5 years | 6.989% |
| 10 years | 6.793% |
| 30 years (the APR) | 6.695% |
The disclosed APR of 6.695% is accurate only for the borrower who makes all 360 payments. Someone who refinances after three years paid an effective 7.256%.
This is why APR can point to the wrong loan. A loan with a low rate and high fees can show a lower APR than one with a slightly higher rate and no fees, and still be the more expensive choice for a borrower who moves within a few years.
What goes into the APR and what does not
Under the federal Truth in Lending rules, the APR is built from the finance charge: costs imposed by the lender as a condition of the credit. That generally includes origination fees, discount points, and mortgage insurance premiums.
It generally excludes charges that would be paid in a comparable cash purchase or that go to third parties for genuine services, such as appraisal fees, title insurance, and government recording fees, provided they are bona fide and reasonable.
Two consequences follow. APR understates total closing costs, because those excluded items are real money. And two lenders can classify a borderline fee differently, so comparing APRs works best alongside the itemized closing costs on the Loan Estimate.
Discount points are the clearest case
Paying points is buying a lower rate with an upfront fee, which makes it the same trade APR describes.
Suppose one point, $3,000, lowers the rate on this loan from 6.5% to 6.25%. The payment falls from $1,896.20 to $1,847.15, a saving of $49.05 a month. Dividing the cost by the saving, $3,000 by $49.05, gives 61 months. Keep the loan longer than about five years and the point paid for itself. Leave sooner and it did not.
That break-even is the practical version of the holding-period table above, and it is usually the more useful number.
Where APR means something different
On a credit card, the APR is simply the annual interest rate. There are no closing fees folded in, and because interest compounds on unpaid balances, the effective annual cost is above the stated APR. An adjustable-rate mortgage's APR rests on an assumption about future rates that will not hold exactly. The comparison above applies to fixed-rate closed-end loans.
Try it with your own numbers
The APR calculator converts a rate and a set of fees into an APR. The mortgage points break-even calculator tests whether paying points is worth it for the time you expect to keep the loan, and the refinance break-even calculator does the same for closing costs on a refinance. The interest rate calculator works back from a payment to the rate behind it.
Sources
- Regulation Z (Truth in Lending), 12 CFR Part 1026, including the definition of the finance charge and the accuracy tolerances for the disclosed annual percentage rate. ecfr.gov/current/title-12/chapter-X/part-1026
- Regulation Z, Appendix J to Part 1026, the actuarial method for computing the annual percentage rate on closed-end credit. ecfr.gov/current/title-12/chapter-X/part-1026/appendix-Appendix%20J%20to%20Part%201026