When shopping for a mortgage, lenders will typically provide two different numbers to show the cost of borrowing the money.
- The mortgage interest rate, which is related to the cost of borrowing the principal amount of the loan. It is the cost you will pay each year to borrow the money, expressed as a percentage rate. The rate can be fixed or variable, but when it is a variable rate loan, the APR does not reflect the maximum interest rate of the loan.
- Annual percentage rate (APR) reflects not only the interest rate but also any points, mortgage origination fees, and other charges that you pay to get the loan.
What is an Annual Percentage Rate vs Interest Rates?
The APR is important because it can give you a good idea of how much you’ll pay on an annual basis for the funds borrowed.
Lenders are obligated to disclose the APR in addition to the interest rate. Since lenders charge different fees, this disclosure was meant to help consumers understand the actual rate for the funds borrowed, which includes the finance charges in addition to the interest rate charged on the principal balance of the loan.
The APR also helps consumers compare overall costs from one lender to the next. Be careful when comparing the APR of a fixed rate loan with the APR of adjustable or variable rate loans, or when comparing the APRs of different adjustable rate loans. You should also know the fees included in the APR, because lender fees and other costs can vary from lender to lender.
What is an Annual Percentage Rate for Mortgages?
While interest is charged on the principal loan balance owed monthly, the APR also includes the other charges or fees and is calculated by spreading your upfront costs over the life of the loan and expressing this as a percentage of the loan amount that you pay each year.
That matters because if you pay off a loan early, your “true” APR may be higher than the one on your loan documents since those costs will be spread over a shorter time period. If your loan includes prepayment penalties, then your actual costs will be even higher, so in some cases the APR your lender provides will be a poor gauge of your actual expenses.
While this may cause the APR to be higher when recalculated based on the shorter period of time you have the loan, you will most likely save a lot of money by paying down your mortgage or paying it off early. You will pay less in actual interest than if you take the full term of the loan to pay it off.
Remember, the amount of your mortgage payment each month that is applied to interest is calculated on the actual principal balance owed. The lower the principal balance the interest is calculated on, the greater the portion of your monthly payment that gets applied back to that principal balance.
Another way APR can be misleading is if you take out a mortgage with a variable interest rate. While APR is intended to more accurately reflect the total cost of your loan, if interest rates rise, and your interest rate adjusts to the maximum allowed under the original terms of the loan, then the APR originally disclosed may not be accurate. The APR a lender discloses on a variable rate loan does not reflect the maximum interest rate on that loan.
APR is One Piece of the Puzzle
What is an Annual Percentage Rate benefit? All smart shoppers want to minimize the cost of borrowing. If you plan to stay in the same home for the entire term of your mortgage, the APR can be one yardstick for comparing fixed-rate loan offers.
But, the overwhelming majority of people move before they’ve completely paid off their mortgage, either upsizing as their family grows, downsizing as they near or enter retirement, or simply moving for work or family reasons.
Likewise, some homebuyers shop for a variable-rate mortgage. If any of this sounds more like you, then minimizing your upfront expenses could be more financially advantageous, even if it means paying a slightly higher interest rate.
Low upfront fees and a higher interest rate could result in a higher APR, so in this case, comparing only APRs while excluding other factors may not provide you with the most accurate way to make a comparison.
What is an Annual Percentage Rate? APR is a useful standardized tool to determine the cost of the funds you are borrowing on a fixed rate loan. It can also be helpful when comparing competing loan products, but it’s just one tool. It’s important to take a hard look at the interest rate and lender fees in a Loan Estimate rather than counting on the APR to tell the whole story.