APR vs. Interest Rate on Mortgage
The APR and interest rate are important numbers when choosing a mortgage loan. But what is more important?
Some experts say that the APR is the most important because it includes your interest rate and your loan fees. This is the “real” cost of a mortgage.
However, the APR is often too broad to be a good comparison tool.
Today's mortgage buyers have a lot of flexibility in choosing their interest rates and upfront fees. So instead of just looking for the lowest APR or interest rate, you should choose the combination of short-term and long-term costs that makes sense for you.
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What is APR?
The annual percentage of a loan (APR) measures the total cost of borrowing. The annual interest rate is intended to represent the long-term cost of a loan from the closing date to the date it is repaid.
Instead of just looking at the interest rate, the APR for a mortgage includes lender fees and charges such as:
Mortgage Insurance Discount PointsMortgage FeesOther Closing Costs
Mortgage lenders are required by the Truth In Lending Act to disclose the APR of a home loan, as well as the interest rate, each time they submit a loan offer.
The APR is included in the credit estimate that you receive from each lender with prior approval. It is provided so that borrowers can make a more informed decision when it comes to loan decisions.
How is the APR calculated?
The annual percentage rate is calculated by taking the total cost of upfront charges on a mortgage loan and then spreading it over the life of the loan to estimate the annual cost. This is added to the interest rate to determine the “actual” annual financing costs.
"This shows the actual amount you will pay on top of the balance of the mortgage," said John Davis, ScoreSense Education Ambassador.
However, not all credit institutions consider the same fees in their APR calculation.
"The law requires the APR to include interest, points, loan origination fee, brokerage fee and mortgage insurance," said Scott Auen, senior vice president of retail lending at Cornerstone Bank.
“There are also third party fees that cannot be taken into account legally, e.g. B. Notary, appraisal and legal fees. And there are other fees that some lenders include while others don't. "
This means that the APR is not a perfect way to compare apple to apple mortgage loans. You also need to consider the interest rate and the total upfront fees.
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What is the difference between APR and interest rate?
A mortgage rate is just the amount you pay your lender in interest each year. The APR includes interest as well as loan fees. It measures the total amount that you are paying over and above the principal of the loan. That means the APR is usually higher than your interest rate.
“The interest rate indicates what you would expect on your mortgage monthly,” explains Auen.
"The APR, on the other hand, should give you a more complete picture of the total cost of your mortgage loan over the life of your loan."
When requesting a lender quote, the most popular number is usually the interest rate. But APR must also be included.
You might think that APR is a better way to compare mortgage offers than just the interest rates. Don't you want to know which loan has lower overall costs – not just a lower mortgage rate?
Well, not necessarily. There are pros and cons to using either APR or an interest rate to buy a mortgage loan.
Advantages of the APR comparison
The interest rate is usually the first number that most home buyers look at. But it can be deceiving.
For example, the rate quoted on an FHA mortgage might seem enticingly low. The rates quoted for FHA loans are usually lower than the rates for a comparable traditional loan.
Since an FHA loan requires annual mortgage insurance, which costs 0.85% of the loan amount each year, the annual interest rate is often higher than a traditional loan.
The annual percentage rate is often a better tool for comparing multiple loan products: for example, an FHA loan versus a traditional loan.
Factors like your credit score and down payment also make a difference when it comes to loan fees and APR.
"APR is often a better tool for comparing multiple loan products," said Nishank Khanna, chief financial officer of Clarify Capital.
“If you have a low rate loan but a lot of fees, calculating the cost of APR will help you understand how much you are really saving or spending.
“The annual percentage rate is a more complete measure of comparing mortgages with different interest rates and total fees. It levels the playing field and allows you to see things from the perspective of apples to apples, ”continues Khanna.
Cons of Using APR to Compare Loans
However, for many borrowers, the APR is not a realistic way to compare costs.
This is because there are a few important assumptions made in calculating the APR:
APR assumes that you keep your loan for the entire term. APR assumes that you are not selling or refinancing the home. APR assumes that you will not repay the loan early
Most borrowers do not pay off their mortgage in full. It is typical to sell or refinance after just a few years. Comparing the loans based on their long-term costs may not make sense.
And the APR does not take into account different financial priorities.
For example, some borrowers pay discount points. Points can add thousands to your upfront fees but lower your interest rate significantly.
“In this case, lower mortgage payments or building equity are a priority. So it may be wiser to invest more stocks in the interest number than the APR number, ”suggests Khanna.
On the other hand, some borrowers want or need to save money on completion.
You may accept a lender with a higher interest rate and a higher APR if they are willing to cover some of their upfront costs.
"In this scenario, a loan with a higher interest rate and fewer up-front fees can be cheaper month to month," says Khanna.
"Borrowers should consider how much cash they have and what they are happy to pay for straight away, rather than simply taking out a loan at the lowest APR."
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When to Use APR vs. Interest Rate
Be careful not to overstate the APR number. APR is most useful when you want to keep the loan for the entire term.
"If you're buying a home that you plan to move or refinance within 5 to 10 years, it makes more sense to look at the interest rates so you can keep your monthly payments lower," says Auen.
Also, keep in mind that lenders don't include the exact same cost in their APR calculations.
"Therefore, you should specifically ask what is in your APR so that you can make an accurate assessment when comparing offers," says Auen.
If you only plan to stay home for a few years, comparing the 5 year cost of each loan might be more helpful than the annual percentage rate.
You can find the 5-year cost forecast on page 3 of your credit estimate just above the APR. It shows the real cost of your loan after 5 years, including loan capital, interest and upfront costs.
This number is more realistic for a short-term borrower than the APR, which spreads the cost of borrowing over the life of the loan – often 30 years.
Fixed or floating rate mortgage APRs
With a fixed rate mortgage, the APR is almost always higher than the interest rate. This is because your interest rate stays the same over the life of the loan. So if you add fees on top of the fixed rate, the APR naturally increases.
But what about a variable rate mortgage?
If you compare the ARM interest rates, you might notice something strange: the APR may actually be lower than the interest rate.
This is not because ARMs have low or no loan fees. Rather, this is due to the way lenders calculate the APR for a floating rate loan.
The annual percentage of an ARM is based on the index rate to which your loan is tied. An index is just a measure of the economic conditions at that time, expressed in an interest rate.
However, ARM APRs assume that the index rate will remain the same over the life of the loan. Unlikely.
Let's say you take out a 5/1 ARM. Your initial interest rate is 3.5% and your margin is 2.25%. On the day your loan ends, the index rate that your loan is tied to is 0.5%.
Initial interest rate: 3.5% Index rate on completion: 0.5% Margin of your loan: 2.25% APR: 2.75%
This calculation can make ARMs look incredibly attractive in a low price period like the one we're in right now – especially if you're shopping based on the APR.
However, this calculation assumes that your interest rate will go down as the loan finally adjusts. If you take out the ARM when interest rates are at the bottom, it is unlikely. Your interest rate and monthly mortgage payment are more likely to increase.
So don't be fooled by the extremely low APR on a variable rate mortgage. This is an estimate based on some large assumptions
And many borrowers will definitely sell or refinance before their ARM's fixed income period is up.
How to Find the Best Mortgage Deal
As you think about the annual percentage rate versus the interest rate, keep in mind that this is not one or the other. You can (and should) look at both numbers.
"Consider both the interest rate and the annual percentage rate when deciding on a mortgage," recommends Davis.
“You can first use the interest rate as a tool to filter out your options. Once you have shortlisted the preferred rate offers, you can carefully compare the APRs of those offers to get the best possible deal. "
If you have a good credit score, use it to your advantage.
"If you have good credit but can't decide between two lenders who have similar repayment terms – one with a lower interest rate but a higher APR, and the other with a lower APR but a higher interest rate – try Negotiate both terms, "advises Davis.
"The goal is to either lower the fees or the interest rate to match or exceed the other offering."
When in doubt and want the best results, reach out to a mortgage professional who can help you determine the best loan deals based on the annual percentage rate of interest.
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