Interest Rate vs. APR: How to Compare Mortgages
Buying a home is often an exciting step closer to financial freedom. Unfortunately, however, the mortgage process can leave homeowners scratching their heads. Most first-time buyers know to sock away cash for a large down payment, but how many know the difference between an interest rate and APR? This article will help clarify this specific aspect of the mortgage process.
The difference between interest rate and APR
The interest rate on your mortgage is simply the amount you’ll pay a lender beyond the principal (the amount of money you originally agreed to repay); it does not reflect any fees or other charges you may incur to obtain the loan. Various factors help determine this number including prevailing rates, your credit score, loan-to-value ratio, property type, and loan type (fixed vs. adjustable, etc.).
The annual percentage rate (APR), meanwhile, is a broader measure of your mortgage cost and—in addition to interest—often includes fees and other charges you’ll pay to obtain the loan (e.g., mortgage insurance, most closing costs, discount points, and loan origination fees). The APR is therefore almost always higher than the mortgage rate.
In theory, APRs were designed to make it easier for shoppers to evaluate various mortgage lenders by providing a complete picture of mortgage costs. For example, if you stumble upon an advertised APR that mimics the interest rate during your research, you’ll know that particular lender charges fewer fees. Sounds relatively straightforward, right? Unfortunately, APRs aren’t always so clear-cut.
APR limitations
First and foremost, lenders aren’t required to include all of their fees in an APR: meaning that if you’re looking for standardization across the industry, prepare to be disappointed. Consequently, fees included in an advertised APR vary across lenders; some options may even include those you may not even want or need such as discount points (fees paid to a lender for a reduced interest rate). It’s therefore imperative to understand which fees are (and aren’t) included when you shop around. Simply put, don’t automatically assume the lowest APR is the best deal in town.
APRs also aren’t an accurate reflection of the total borrowing cost as they may underestimate the actual cost of your loan—with the math used to determine an APR assuming you’ll pay the mortgage off based on your term (20 years, 30 years, etc.). While fees are thus calculated by amortizing them across the entire life of the loan, the reality is that most homeowners hold on to their mortgages for a shorter duration than their original term (primarily due to refinancing or selling). Consequently, your mortgage may actually be more expensive as you’ll pay off corresponding fees over a shorter period of time.
An APR is also inefficient with respect to adjustable-rate mortgages (ARMs) as—just like the previous example—advertised APRs sometimes understate total borrowing costs. That’s because the APR calculation for these types of loans is based on somewhat arbitrary assumptions about future interest rate adjustments (beyond the fixed-rate period of an adjustable-rate mortgage). These assumptions aren’t guaranteed, meaning a variable-rate APR is also uncertain: especially since it’s impossible to predict future interest rates.
Some scenarios also exist wherein an APR may either equal or fall below your interest rate. Common examples include when the lender rebates most or all of its (and third-party) fees—such as appraisals and title insurance—or makes assumptions (on future rates, etc.) when calculating adjustable-rate mortgage (ARM) products.
The best approach when shopping around for a mortgage
Step one: perform the required research
So, just how can you find the best mortgage lender(s)? For starters, familiarize yourself with various types including banks, credit unions, and brokers—and ensure they’re registered in your state. You can also search the Better Business Bureau or J.D. Power mortgage customer satisfaction rankings and make sure your selected lenders offer the mortgage product(s) you’re interested in.
Once you’ve narrowed your search, inquire (with each lender) about turnaround times, lender fees, and all other costs you’d be responsible for at the time of application and closing. You can also explore the possibility of rolling any fees into your mortgage. Track everything on a spreadsheet listing all mortgage details including the rate, monthly payment, fees (each itemized), and additional considerations (e.g., rate-lock-in), and use this online tool to calculate the APR. This itemization will help you feel more confident you’ll nab the best deal.
Step 2: seek pre-approval
If you believe you’re ready to tackle homeownership, the next step is to obtain a mortgage pre-approval letter documenting exactly how much money you’re qualified to borrow.
This letter differs from a prequalification, which is a simpler evaluation using self-reported income—rather than a hard credit inquiry—that provides an idea of how much of a loan you’ll likely qualify for. A pre-approval, on the other hand, is a conditional commitment to grant you the mortgage.
Step 3: kickstart the application process
After you apply, lenders are required by law to provide (within three business days) a three-page home loan estimate detailing all information about the loan including monthly expenses, interest rate, fees, and closing costs should both parties agree to move forward (take no action if you choose not to proceed with the lender). Obtaining two to three loan estimates from various lenders is not only a good idea—and a great way to “dot your Is and cross your Ts” with respect to your initial research—but doing so won’t hurt your credit provided you complete these within a 45-day window. It’s also wise to apply with various lenders on the same day as mortgage rates fluctuate on a daily basis.
In sum: why a lower APR isn’t necessarily the best loan
Now that you’re better equipped to understand the difference between an APR and interest rate, hopefully you’ll experience less head-scratching (and more cost-savings!) as you forge ahead with the mortgage process.
FAQs
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To calculate an APR on your mortgage, firms will add up your loan’s fees and interest and divide that number by your principal. They’ll then divide that result by the number of repayment term days. Multiply that number by 365, and then again by 100, and the result is your APR. The formula is as follows, where n = the number of days in your loan term:
APR = ((Interest charges + fees) / Principal / n x 365) x 100
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These are most often paid up-front at the time the loan is taken out and not spread out over monthly payments.
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They do this by considering a variety of factors, which may include:
· Your credit score: This is a crucial component in determining your interest rate, as banks typically offer lower rates to individuals with higher credit scores who are naturally considered less risky borrowers.
· Loan amount: The amount of money you are borrowing can play a role in determining your interest rate, as higher interest rates generally accompany larger loan amounts.
· Debt-to-income ratio (DTI): Banks also assess your DTI, which is determined by dividing your total monthly debt by your gross monthly income. This figure is principally used by lenders—in addition to your credit profile—to assess whether you’re a good candidate for a loan or mortgage. As one might expect, the lower your DTI, the better. A “good” DTI likely falls under 35%, but if you can push it even lower, lenders will be more likely to lend to you (note thresholds do vary by lender).
· Additional upfront fees: Some lenders may charge upfront fees to secure a lower interest rate, which are often paid at the beginning of the loan term and can help lower your overall interest rate.
· Down payment amount: With respect to mortgages or auto loans, the size of your down payment can impact your interest rate (with a larger down payment often resulting in a lower rate).
· Length of the loan: Lower interest rates typically accompany shorter loan terms as they pose less risk to the lender (with the opposite true for longer terms).
By considering these factors, banks can determine an appropriate interest rate tailored to each individual borrower's circumstances. It’s important to note that interest rates advertised by banks are typically reserved for customers with the highest credit scores, so the rate offered to you might differ based on these influencing factors.
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Consider the interest rate, not the APR, in this case—as fees included in the APR are typically paid up-front and not spread out over monthly payments.
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A straightforward answer doesn’t exist in this case, as your APR will depend on a variety of factors including rates offered by other financial institutions, your credit score, and the prime rate set by the central bank. Shop around to ensure you get a good deal.
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.
Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.