Like any large purchase, you’ll want to shop around for the best mortgage that you can find. But, you must make sure that you compare apples to apples when you look at the interest rate for your mortgage.
Mortgage lenders typically show two different interest rates to borrowers, the mortgage interest rate and annual percentage rate, or APR. Understanding the difference between each rate and ensuring that you’re comparing the same rates across all of the mortgages you’re considering could save you thousands of dollars over the long term.
Your APR measures additional important, but different, costs that lenders add to your home loan. It’s important to understand how lenders calculate an APR for your mortgage and how it compares to the simple interest rate.
What Is APR?
The interest rate that lenders advertise for a mortgage is simply the cost to borrow the principal loan amount for your home. It doesn’t include any fees from the lender, and the interest rate can either be variable or fixed. The interest rate lenders charge customers depends on several factors like your loan type, loan length, down payment, your credit score, and other factors. The interest rate is the base fee and always stated as a percentage.
Understanding your interest rate is very important because it directly affects monthly payments, unlike your APR. The interest rate is one way to compare mortgages from multiple lenders, but it does not factor in all of your costs.
The annual percentage rate, or APR, shows the true cost of your mortgage. It is the total cost expressed as a percentage. The APR includes the interest rate plus and adds any upfront costs or fees that you must pay to the lender. Lenders often charge points, fees, or other costs to borrowers in order to receive a lower rate or to even close on a deal. The APR is a more encompassing measure of the true cost of your mortgage since it includes other costs like discount points, closing costs, and brokerage fees in addition to the simple mortgage interest rate.
APR helps consumers understand the comparisons between interest rate and the fees they pay at closing. Borrowers may typically find mortgages with higher upfront fees in exchange for lower interest rates. Or lenders like to increase an interest to cover closing costs. These higher fees essentially hide the closing costs within them, and consumers must look at the APR to get the full picture of what they are paying. The government, through the Truth in Lending Act, requires lenders to show borrowers the APR next to the interest rate.
Why Lenders Talk About APR
Lenders talk about APR because they have to. It’s the law. The Truth in Lending Act requires that lenders disclose credit terms so consumers can easily compare multiple loans with different credit terms and make an informed decision for the best mortgage that meets their needs.
Before Truth in Lending Act, it was difficult for borrowers to accurately compare mortgages because lenders did not present their interest rates the same way. The law now requires that mortgage company show loans with the same terminology and interest rate calculations. Consumers can now look at the APR of mortgages as a single means of comparison.
But, consumers should still look at an itemized list of the fees their lenders use when calculating their APR. There is a little flexibility for banks to either include or leave off some small fees like the courier fee, for example.
How Is APR Calculated?
Like previously mentioned, mortgage APRs include lender fees, closing costs, and other fees that lenders amortize over the course of the life of the mortgage. You don’t see these fees upfront necessarily. They are buried in the total cost of the loan and added to your monthly payments.
So, for example, if your original mortgage was for $250,000 home at a 3.5% interest rate, you may see an APR of 3.75% or so after the fees and costs lenders add to the loan. So, in our example, if you paid the fees and closing costs upfront, you might find yourself having a monthly mortgage payment of about $1,123 before private mortgage insurance (PMI), property taxes, and homeowner’s insurance. If you rolled all of those costs into your mortgage and used the 3.75% APR, your mortgage payment would be about $1,158 before PMI, taxes, and insurance. And, of course, you wouldn’t owe the closing costs, lenders fees, and other fees at the time of closing. You pay for it over the course of your loan.
Now the $35 per month between the two rates in our example may not seem like a lot, but it adds up quickly. The difference is $420 per year or $12,600 over the course of a 30-year mortgage. It truly is a classic cost-benefit analysis. You’re paying $35 extra per month to roll your closing cost and fees into your loan instead of paying the thousands of dollars upfront at the time of closing.
Will you spend less money in fees before you sell your house? Or, should you have paid the fees or points up front to lower your mortgage’s interest rate? It’s all a matter of timing. When do you plan on selling? Do you plan on living in your house for over 30 years?
The Danger of Only Looking at an Interest Rate
There are the dangers for borrowers if you only know your interest rate and not your APR too. You can focus on your interest rate if you are only concerned about having a lower monthly payment for your mortgage. But, looking at your interest rate doesn’t take into consideration the other fees associated with your loan. Looking at a loan’s APR forces borrowers to consider other fees and costs that lenders include in the total cost of a loan.
If you understand the APR of any loans that you are considering, you can compare the mortgages from multiple lenders. Comparing mortgages using their annual percentage rates can help you compare apples to apples and oranges to oranges and possibly save thousands of dollars.
For example, even if different lenders advertise two mortgages with the same interest rate, the APR will most likely be different because of one’s higher fees or closing costs that one lender charges over another to the borrower to finance that loan. Lenders can also offer a higher interest rate and lower costs in an attempt to sway consumers.
In most cases, it typically makes sense to look at mortgages with a lower APR especially if you’re going to live in your how for a long time. Most borrowers don’t stay in their homes very long though. The average length of a mortgage is typically seven to eight years until the borrower typically sells the home and moves on or refinances. If you don’t keep your mortgage loan for the full term, a loan’s APR can make some mortgages artificially look better than they are in the long-term.
If you plan to live in your for 30 years or more, it may make sense to consider loans with the lowest APR. But, if you don’t plan on living in your house for the full term of your mortgage loan, it may make sense for you to pay fewer fees at closing even if that means a higher interest rate. It truly pays for you to consider all of the variables of a loan, how long you plan to stay in your home when you move, the upfront costs and fees, and other attributes of your loan when deciding on the best mortgage. Because an APR spreads fees and closing costs over the length of the entire loan, the savings really hits home if you stay in your house for a long time.
Buying a home and taking out a mortgage to pay for it are big decisions. The type of mortgage that you borrow will have financial implications for your family potentially for decades to come. It is important that you understand the difference between mortgage interest rates and annual percentage rates. Knowing the differences and comparing apples to apples when shopping for a mortgage can save you thousands of dollars in the long run.