APR, or annual percentage rate, is a term you are certain to come across when you’re in the process of getting a mortgage. It’s really important to know what it means and how it affects your mortgage because it can greatly impact which loan you choose and how much you end up spending throughout the life of your new loan.
What is APR?
APR is the number that helps you evaluate the true cost of the mortgage you’re about to get. It does include the interest rate of the loan, but it also includes mortgage origination fees, points, and the other costs associated with getting a mortgage. The APR is almost always higher than the interest rate because it includes all these other costs.
However, not all lenders include all fees in the APR—they often don’t include appraisal, inspection, and credit reporting fees. It’s important to ask the lender what isn’t included in the APR so you can make an accurate comparison with other loans.
How Interest Rate and APR are Different
An interest rate is just the rate that accumulates on the money you’ve borrowed. If you owe $200,000 and your interest rate is 5 percent, you’ll pay $10,000 annually in interest. And a portion of that will be part of your monthly mortgage payment.
APR is how much you pay including interest and all the other costs associated with the mortgage. APR is a more accurate reflection of the true, big-picture cost of the loan.
The interest rate is decided by current rates and your credit score. Your monthly payment is based on this interest rate and the balance of the loan you’re getting. Your monthly payment is not based on APR, however. The APR is actually decided by the lender, because it includes all of the lender fees.
Why You Need Both Numbers
So, why do you need both of these numbers—interest rate and APR? They each give you different information about your loan.
You should compare interest rates because that number is a big part of your monthly payment. If you have a lower rate, you’ll pay less in interest throughout the life of the loan.
You also need to compare APRs because interest isn’t the only cost you’ll be paying for when you get the loan.
Remember, when you review Loan Estimates and compare all of your options, don’t compare a mortgage interest rate to an APR, because they are not the same thing.
Using Interest Rate and APR to Compare Loans
In general, the higher the APR, the higher your monthly payments will be. Comparing APR is a great way to comparison shop so you can see how much you’ll pay over the entire life of the loans you’re comparing.
However, if you’re planning to stay in your home for less than the full term of the loan, APR is not the best way to evaluate the total cost of your mortgage. This is because it accounts for one-time fees that you only pay at the beginning of the mortgage.
If you’re going to be in your home for a long time, take the loan with the lowest APR, because it will cost you the least to finance, even if the interest rate is higher than some of the other loans you’re comparing.
If you’re not going to be in the home for the full term, you may want to take the loan with fewer upfront fees but a higher APR because the total cost is less over the first few years.
It’s especially important to look at your interest rate here and do the math with a projected selling (or refinance) date in mind.
The interest rate and APR combined will help you calculate your breakeven point for different loans. These are complicated scenarios, however, so it’s best to ask a lender for help to make sure you’re calculating correctly (or you can use a calculator like this one.)
APRs on ARM Loans
APRs are far more useful in comparing fixed-rate loans rather than adjustable-rate loans, or ARMs. This is because ARM APRs are based on assumptions about any future rate adjustments. The APR is calculated based on the assumption that the loan is fixed for its introductory period and then adjusts based on today’s economic index values for the next 25 years.
But in five years, when the rate starts to adjust, it’s highly unlikely that the economic index values will be the same as they are right now. In fact, an APR for an ARM loan on a Monday could be different than the APR for an ARM loan on a Friday of the same week.
To truly compare APRs for ARM loans, get all mortgage quotes on the same day and as close to the same time as possible. Compare APRs on the same loan type and term, including the adjustment term.
Have any Questions?
If you have any questions about APR, I understand! This can be a complicated topic. I’m here to help however I can, so please don’t hesitate to reach out.