Many mortgage shoppers are confused about the difference between a loan’s interest rate and its APR, or annual percentage rate. Understanding APR can be extremely valuable, because it can allow you to compare different loans more effectively and figure out which one is truly best for you.
But you’ll also want to understand the limits of APR, and why a loan with a better APR might not necessarily be a better loan given your specific circumstances.
Interest rates are simple – they’re the cost of borrowing money. All other things being equal, a loan with a 4% interest rate is better than a loan with a 5% interest rate.
But the problem with mortgages is that all other things are seldom equal, because different lenders charge different amounts for closing costs and other expenses. That’s where APR comes in. APR is designed to compare the true cost of a loan when these other expenses are taken into account.
APR calculates the cost of a loan including not only the interest rate but also any points, prepaid interest, private mortgage insurance, and fees for loan processing, underwriting, document preparation, administration, escrow and settlement. In addition, APR may take into account loan application fees and any insurance to pay off the loan in the event the borrower passes away.
Here’s an example of how it works: Suppose you’re borrowing $100,000 and you have two loan offers. One has a 5% interest rate and $1,000 in costs. The other has a 4.5% interest rate, but $4,000 in costs. Which is better?
APR lets you make an apples-to-apples comparison. In this case, the APR of the first loan is 5.09%, whereas the APR of the second loan is only 4.85%. So the second loan is a better deal.
APR also lets you make an apples-to-apples comparison if you’re looking at loans with different principal amounts, so you can decide whether it’s worth it to make a larger down payment.
But as valuable as APR is, it has its limits. For example, APR is generally calculated assuming that you will pay off your mortgage over the full term of the loan. In the example above, the APR calculation assumes that both loans are for a 30-year fixed term and that you will pay off the loan over 30 years.
But let’s assume instead that you’ll sell the house after five years. If you change the term of the loan to five years, then the APR for the first loan is 5.41%, whereas the APR for the second loan is 6.12%. So in that case, the first loan turns out to be much better.
That’s why you should always consider how long you’ll be likely to own a house when calculating your APR. And even if you plan to stay in the house for a long time, you should also consider whether you’ll refinance at some point or try to pay off the mortgage more quickly. If you take out a 30-year mortgage but refinance it in 15 years, or pay it off in 20 years, that can dramatically affect your APR.
You should also know that APR is much more useful when comparing two fixed-rate mortgages, as opposed to comparing different adjustable-rate mortgages or comparing a fixed-rate loan to an adjustable loan. The reason is that APR assumes that the interest rate on an adjustable loan will stay the same, whereas it’s highly likely that the interest rate will go up or down at some point. So in addition to the APR, you’ll want to consider your expectations about interest rates and your tolerance for risk.
While APR takes into account many mortgage costs, it doesn’t factor in all of them. Typically, APR doesn’t include payments to third parties for title costs, home inspections, recording and legal fees, transfer taxes, notary fees, credit reports or appraisals.
Some lenders will offer you a credit to offset your closing costs, but this might not be included in the initial loan estimate document you receive. And you might decide to pay some closing costs yourself rather than rolling them into the loan. These things can also affect your final APR.
And of course, even a loan with a great APR is no bargain if you’ll have trouble making the monthly payments.