When you take out a mortgage, you’ll be paying an interest portion on each monthly payment in addition to contributing to the principal. The mortgage rate that you’re quoted makes a big difference in the overall cost of your mortgage.
But what about the annual percentage rate (APR)? How does this rate differ from the mortgage rate, and more importantly, how will it affect the costs associated with your mortgage?
Understanding the difference between these two crucial rates could save you a ton of money on your home loan.
What is a Mortgage Interest Rate?
The mortgage interest rate is a percentage of your loan amount that you are charged for borrowing the funds needed to make a home purchase. This is an essential component that you should use to compare different mortgages from different lenders.
It’s also an important factor to look at to get a basic understanding of how much your monthly mortgage payments will be. Essentially, the interest rate is the base rate before any additional fees and charges are tacked on.
What is the Annual Percentage Rate (APR)?
Mortgages can often be confusing. With so many different quotes involving so many different numbers, it can be tough to decipher which home loan is better or more affordable than the other. Some quotes you obtain could include specific costs that you’ll likely pay, while some may not.
Most of the time lenders are very upfront and detailed with the quotes they offer to borrowers. However, it can still be hard to tell which one is the most cost-effective since interest rates and fees will differ.
The APR can help you compare apples to apples by taking all costs related to borrowing into consideration. It includes the interest rate as described above, but also various other fees that borrowers are charged when they take out a mortgage. This includes buy-down points, loan origination fees, mortgage insurance, and the majority of closing costs.
The APR is therefore usually (but not necessarily always) higher than the mortgage interest rate because of all these extra fees added on. As such, the APR provides a more in-depth idea of how expensive a home loan will be, as it is an all-encompassing rate that factors in all associated mortgage fees.
Both the interest rate and APR are clearly outlined in loan documents as per the Truth in Lending Act to allow borrowers to make an informed decision before settling on a mortgage. The primary difference between the interest rate and APR is that the interest rate calculates the monthly payment, while the APR calculates the entire cost of the mortgage.
Generally speaking, a lower APR means the total cost of the loan is lower.
APR is Not Without its Weaknesses
The APR certainly provides borrowers with a solid starting point to compare mortgages, but it’s not free of drawbacks. The biggest flaw with the APR arises when different lenders apply different fee structures in their APR calculations for their loan programs. That’s why it’s important to inquire with the lender regarding what is and is not included in the APR.
In addition, APRs might be tricky when comparing adjustable-rate mortgage (ARM) loans. For these types of mortgages, the APR doesn’t reflect the maximum interest rate of the home loan. The interest rate for an ARM may fluctuate at any time, which makes it a lot more challenging to compare the APRs of ARMs to fixed-rate mortgages.
Lastly, if you ever plan to pay down your home loan early, refinance at some point, or move in the near future, an ARM comparison might not be as useful as comparing the interest rate. That’s because the APR is a representation of the entire cost of the borrowing over the life of the mortgage.
The APR spreads out the fees that are paid upfront over the life of the mortgage, so the comparison of APR is only useful if you’re planning to keep the home loan for its full length.
Since the majority of borrowers don’t hold onto their mortgage for the full amortization period, the APR can make it tough to decipher which mortgage is better than the other. If you plan to stay put for 30 years, it might make sense to choose a mortgage with the lowest APR because you’ll pay the lowest amount for your home.
But if you’re planning to move or refinance within a few short years, it might make more sense to get a higher interest rate and pay fewer upfront fees with a higher APR because the overall costs over the first little while will be less.
The Bottom Line
Comparing different mortgages with different interest rates and APRs can be rather confusing for the average borrower. Instead of tackling this job on your own, you might be better off working with a mortgage specialist who will be able to shop around for you and find the mortgage package that is most affordable for your particular circumstances.