APR vs. Interest Rate: Why It’s Important to Know the Difference
Whether you're building your investment portfolio or investing in your first rental property, chances are you'll need to take out a mortgage. And, as you're undoubtedly aware, interest rates for these loans have been rising.
To get the best deal, it's important to consider several factors, including the APR vs. interest rate and the steps you can take to reduce these rates.
Let's explore their differences and how they affect you as a landlord.
What is an interest rate?
Understanding how interest rates work is critical when determining when and which investment property to buy. The interest rate is the amount your lender charges you to borrow money, expressed as a percentage of the loan.
Thanks to stubborn inflation and a resilient economy, the Federal Reserve has been steadily raising interest rates. The last hike on May 3 pushed its benchmark rate between 5 and 5.25%, a 16-year high. Keep in mind that this is the interest the banks pay to each other. Because banks are paying more, they'll be charging you more.
On July 3, 2023, the average interest rate for a primary residence came to 6.25%, according to The Mortgage Reports. Investment property rates, however, are often 0.5% to 0.75% higher due to the increased risks lenders take with these types of properties.
Therefore, you may see rates starting at 6.75% to 7% for a single-unit investment property. These rates are based on a borrower with a 740 credit score who puts a 40% down payment on the property. The rates will most likely be higher for those with lower credit scores or less money to put down. Keep in mind, interest rates also vary by lender.
What is an APR?
The annual percentage rate (APR) is the interest rate plus the additional fees the lender charges. It reflects the true cost of borrowing. A mortgage APR may include the following:
- Origination fees: Lenders charge these fees for processing a new loan. It may also include costs for underwriting or verifying that you qualify for the loan. These typically run between 0.5% to 1% for traditional mortgages.
- Closing costs: Closing costs include attorney fees, appraisal fees and escrow funds.
- Broker fees: These reflect the amount you pay a mortgage broker to help initiate a loan.
- Mortgage points: Borrowers pay these fees, also called discount points, to reduce the interest rate and lower monthly payments. Each point generally costs 1% of the mortgage amount. For example, one point on a $200,000 mortgage costs $2,000. Each point typically reduces your interest rate by 0.25%.
- Other miscellaneous lender fees: These could involve late fees, inspection fees and the like.
As you can see, the APR is greater than the interest rate because it includes the fees your lender charges. A lower APR means your lender is charging fewer upfront fees. Thanks to the Truth in Lending Act (TILA), your lender must disclose both the interest rate and APR. Here's an example of the difference between an interest rate and an APR:
You pay 20% down on a $250,000 property. You take out a 30-year fixed-rate mortgage for the remaining $200,000 at 6% interest. Your annual interest expense comes to $12,000.
If your loan fees come to $5,000, your total loan is $205,000. At 6% interest, your new annual interest expense comes to $12,300. Knowing your APR gives you a better idea of how much it will cost over time and makes it easier to determine an accurate return on investment.
The following formula provides you with the APR: $12,300 (annual payment) / $200,000 (original loan amount) = 6.15% APR
As of July 3, 2023, the average APR for a 30-year fixed mortgage for a primary residence is 6.296%. Therefore, landlords can expect an average APR of 6.796% - 7.046% for a single-unit investment property. Remember that these rates vary based on your creditworthiness, the type of property loan and several other factors.
What are the factors that affect your interest rate?
Lenders look at several factors when determining your interest rate, including the following:
- Your credit score: According to Experian, the average FICO Score in the U.S. in 2022 reached 714. A credit score between 670-739 is considered good, 740-799 is very good and a credit score above 800 falls into the exceptional category. A credit score above 700 may qualify you for a lower interest rate.
- Down payment: The larger the down payment you offer, the better chances of a lower interest rate. According to Bankrate, while putting 20% down may secure traditional financing, 25% down may qualify you for better interest rates.
- Type of investment property: Interest rates on a multi-family property are often higher than on a single unit.
- Debt-to-income (DTI) ratio: This ratio is your monthly debt payments divided by your gross monthly income. Lenders generally want to see a DTI ratio of 36% or less for investment properties. This requirement varies based on your other factors.
- Cash reserves: Many lenders require you to have enough reserves in the bank to pay your expenses for at least six months.
Why are interest rates higher on investment properties?
There are several reasons why investment property interest rates are higher than primary residences. The main reason is risk. Lenders know from experience that it's much easier for borrowers to walk away from an investment gone bad than a home.
Also, during an economic downturn, renters may find it more difficult to make their monthly payments. This affects property owners and their ability to repay their mortgages.
Can you get better APR and interest rates by shopping around?
Yes. Always get several quotes before choosing a loan. A lower rate increases your revenue and can save quite a bit of money over the life of your loan. Remember to compare the APR vs. interest rate as it includes all fees and other costs.
Keep in mind there are several types of mortgage loans for investment properties. If you don't qualify for one or need a lower interest rate, consider your options before signing on the dotted line.
A few financing options include conventional loans, HELOCs, home equity loans, portfolio loans, seller financing and government-backed loans like FHA or VA loans. Each of these has its own benefits and requirements.