As a prospective homebuyer, you may be wondering about the meaning of an APR vs. interest rate. An APR (annual percentage rate) represents the true cost of borrowing a mortgage, including the interest rate, lender fees and required third-party costs. The interest rate, on the other hand, represents only what you’ll pay as a direct fee for taking out a loan. But which is the better measure of the value a loan offers you? Keep reading to find out. Show On this page
What is an annual percentage rate?A mortgage annual percentage rate (APR) is a number that captures the total (“true”) cost of borrowing money to buy a home. It represents the interest rate a lender will charge you annually, plus other lender fees and closing costs. APRs are expressed as a percentage and calculated based on the total loan balance. Unlike what you may be used to with credit cards, a given mortgage loan’s APR and interest rate won’t usually be that close to each other — you should expect the interest rate to be lower than the APR because it’s only capturing the amount you’ll pay to borrow money. An APR, on the other hand, typically accounts for several costs and fees, including:
As a result of combining all of these costs and fees into one number, APRs make it easier for consumers to compare loans — even if those loans have different rates and fees. The Truth in Lending Act requires lenders to provide a loan estimate within three days of receiving a mortgage application; APR information can be found on Page 3 of this document. Understanding APR vs. interest rateAs you shop for loans, it may be easiest to compare mortgage offers by referencing their advertised interest rates. Like APRs, interest rates are expressed as a percentage of the total loan balance. But don’t make the mistake of stopping there: Loans that appear similar on the surface — sharing identical interest rates and similar monthly payments — should be compared by APR to ensure you’re clear on the true costs you’ll face over the life of each loan. Consider the following example that compares two different 30-year, fixed-rate $320,000 mortgages. The home’s purchase price is $400,000 for both loans, meaning the borrower made a 20% down payment, and they both carry a 5.61% interest rate. Along with origination fees, both loans have mortgage points — an upfront charge a borrower pays to get a lower mortgage rate. One point is equal to 1% of the loan amount, so each point in the example above costs $3,200. At first glance, Loan A appears to be a better deal since it costs $1,600 less in points and fees than loan B. In addition, the monthly mortgage payment (based on the adjusted loan balance) is about $9 lower than Loan B. However, to truly understand the cost of each loan, we’ll need to calculate each loan’s annual percentage rate and compare. How to calculate the APR on a loanThere are two ways to calculate APR: the actuarial method and the U.S. rule method. Both are acceptable according to federal regulations and, for most people’s purposes, the differences between the methods are negligible — both methods will return the same results (except in cases where payments aren’t made on schedule). You’ll need to use a mortgage APR calculator to determine your rate, because the calculations involve several complex variables that a basic calculator can’t handle. Here are the APRs calculated for our above example loans: We used an online mortgage APR calculator to input the loan costs and fees. As you can see, the APR on Loan A is lower, making it indeed the better deal. Takeaway: If you’re comparing two mortgages that have the same interest rate and appear to be similar, review the APRs to better understand the true cost of each mortgage. How to calculate a mortgage interest rateInterest rates are complex and determined both by factors you can and can’t control. So, although it may be helpful to understand how mortgage rates work at a high level, the most practical thing to do is focus your efforts on what you can control. Here are a few ways you can make sure you get the best interest rate possible in your situation: Improve your creditMore than any other factor, your credit score affects how much lenders will charge you to borrow money. Put yourself in a more favorable position with lenders by making on-time payments for your existing accounts, paying down your outstanding debt balances and removing any errors you may
find on your credit reports. Things You Should KnowYou may notice that, in some cases, you can find loan offers at lower interest rates when you put just under 20% down, compared to a scenario in which you put down 20% or more. This is likely because you’ll be required to pay for private mortgage insurance (PMI), which gives your lender additional protection should you default on the loan. Add the cost of PMI into the calculations, and you may not get a better deal overall even though you’re being offered a lower interest rate. Avoid lender creditsIf you purchase lender credits, the lender will typically lower your closing costs, but there’s a catch — you’ll have to agree to a higher interest rate. Watch out for APRs on ARMsSo far we’ve only been working with fixed-rate loans in our examples. But APR calculations become more complicated — and more limited in their utility — when dealing with adjustable-rate mortgages (ARMs). With ARMs, interest rates will vary over the life of the loan, and at the beginning, they typically have lower interest rates than 30-year fixed-rate mortgages. How ARM interest rates workARMs are structured so the lower APR is only fixed for an initial period, usually between one month and 10 years — and once it’s over, the loan will “adjust” according to a benchmark interest rate known as an index. The lender will then also add a margin — a set amount of percentage points — to the index in order to calculate your interest rate. The timetable associated with an ARM’s fixed and adjustable periods will be right in its name: in the case of a 5/1 ARM, for example, the rate is fixed for the first five years of the loan and then adjusts annually thereafter. Calculating the APR on an ARM is a bit like trying to hit a moving target, as it’s very improbable that in five years, when the interest rate on a 5/1 ARM begins to adjust, the index rate will be at the exact same level it was on the day you closed. It’s also practically impossible that the index rate will stay the same for the remainder of the loan term, when the rate adjusts annually. If you really want to compare ARM rates using APR, you can do so — but you’ll need to understand that the APR won’t reflect the maximum interest rate the loan could reach. To compare ARMs, it’s also important to ensure you’re comparing APRs for loans with the same rate type and repayment term: 30-year fixed to 30-year fixed, 5/1 ARM to 5/1 ARM and so on. Shopping around for a mortgage will help you get the best deal. In fact, nearly half of borrowers who compare multiple loan options will save money on their mortgage, according to a recent LendingTree survey. The lesson here is that, although it may be tempting to settle on one mortgage lender before combing through competitors’ loan offers, taking the time to comparison shop can potentially save you thousands in interest over the life of your loan. Keep the following tips front of mind as you compare offers and prepare to get a mortgage: 1. Focus on APR vs. interest rate based on your needsIt makes
sense to focus on APRs if you care most about getting the best deal on your monthly payments. On the other hand, if you’re more concerned about saving money in the long haul, it’s logical to give more weight to interest rates. 3. Negotiate costs and fees You’ll pay several closing costs when taking out a mortgage — these include underwriting fees, title fees and other third-party charges. When you receive your loan estimates, review these costs and negotiate where you can. → To calculate a break-even point, divide the amount you paid in points by the amount you stand to save each month due to the lower rate. The result will be the number of months you need to remain in the home in order to break even. Is it better to have a lower interest rate or APR?APR is the cost to borrow money, so a lower APR is better for a borrower compared to a higher APR.
What is a good APR for a mortgage?Right now, good mortgage rates for a 15-year fixed loan generally start in the 5% range, while good rates for a 30-year mortgage generally start in the 6% range. At the time this was written in Nov. 2022, the average 30-year fixed rate was 6.61% according to Freddie Mac's weekly survey.
How much higher is APR than interest rate?Be attentive if the APR is more than 0.25% higher than the interest rate for a loan. If you receive disclosures that show a substantially higher APR than the interest rate and you don't understand the disparity between the ARP on your disclosures and/or mortgage quote versus the interest rate, ask your loan officer.
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