What is APR & how it differs from your interest rate
As you set out on your journey toward homeownership, you’ll soon become very familiar with two terms that play a significant role in your search for an affordable mortgage.
APR and interest rate. It’s not uncommon for homebuyers to get a little confused when talking about these terms, especially if they’re just starting to connect with lenders. After all, APR and interest rate are frequently spoken about in the same sentence, expressed as percentages and both are important factors in determining the cost of your mortgage.
Indeed, they are similar—but the distinctions are crucial. The nominal interest rate you pay on your principal is closely related to the daily interest rate as determined by The Fed. Other factors like credit score play an outsized role as well. APR, on the other hand, is the interest rate plus other charges: origination costs, closing costs, fees for discount points, etc.
APR is going to be a larger percentage because of the additional charges rolled into it—but it’s also a superior indicator of total costs. In fact, that’s why APR exists: to give the consumer a clearer indication of total mortgage costs from one lender to the next.
Understanding the differences between these two terms can be extremely helpful as you talk to loan officers and shop for an affordable mortgage.
Interest rate defined
When it comes to purchasing a home, a lender will agree to fund your mortgage provided you promise to not only pay back the principal amount, but also pay interest on the loan. That’s simply the cost of borrowing money. Consider the annual interest rate on your loan to be your “mortgage rate”; the two are virtually interchangeable within the context of home loans. Additionally, this interest is not whimsically generated but rather is the product of broader economic data.
Mortgage rates are driven by the bond market (10-year Treasury notes) as well as the price of mortgage-backed securities. These fluctuations are very much driven by supply, demand and risk.
It’s important to note that The Federal Reserve (The Fed) does not specifically play a role in mortgage rates; it merely sets monetary policies that indirectly shape interest rates, as well as things like inflation and overall market liquidity.
In the context of mortgages, the optimal interest rate is typically provided to individuals who demonstrate the least amount of risk—people with exceptional credit scores. However, lenders strive to make home purchasing available to a wide variety of borrowers, and those with lower credit scores will also be able to obtain a loan, albeit with less attractive interest rates.
That said, the difference between the most favorable mortgage rates and the least favorable can add up to thousands of dollars over the span of a 15-year or 30-year mortgage. This is precisely why it’s so important to create good financial habits at an early age while continuing to monitor your credit score and check your credit report to ensure accuracy.
If the mortgage rate presented to you is determined by external economic data in combination with your most recent credit score, APR, or Annual Percentage Rate, is the total cost of borrowing money from your lender. It’s determined by your mortgage rate plus additional charges and fees your lender includes. Typical fees/charges rolled into APR include the following:
- Origination charges
- Most closing costs
- Costs for discount points
- Mortgage insurance*
Due to these added fees, the APR is always a higher percentage than the interest rate. Both rates need to be thoughtfully weighed and examined as you talk to lenders.
A deeper dive into APR
OK, so now that we’ve defined APR, how does it work in real life when you’re trying to secure a mortgage? How is it used to gain insight into your future monthly payments?
As stated above, APR is a useful indicator for prospective homebuyers because it includes interest rates (mortgage rates) plus all the other costs a lender will pass on to you neatly expressed as an annual percentage.
Just as lenders look to your three-digit credit score for an instant assessment of your likelihood to pay back a loan on time, you can look to APR to see if a particular lender is offering you a good rate, all things considered.
But here’s where it gets tricky: A comparison of APRs between lenders is intended to be an “apples to apples” comparison. However, factors like purchasing discount points and comparing loans of different terms can provide challenges when examining rates. Then there’s the fees/charges. In the calculation of APR, it’s essential to to understand which costs/fees are included and which ones are not. Only when you know this, can you compare rates effectively and find an affordable mortgage whose terms and payment structure meet your needs.
The full costs represented in APR
The Truth in Lending Act (TILA) of 1968 requires that all lenders disclose the APR in any loan agreement and all the terms of the loan before asking the borrower to consummate the transaction. This is an important act of transparency.
However, TILA does not mandate that all mortgage-related charges be included or itemized. Typically, there are certain costs that are NOT absorbed into the APR, and they include the following:
- Appraisals fees
- Credit reports
- Application fees
- Notary fees
- Attorney fees
- Title fees
- Document preparation fees
This is why you need to be a proactive, educated consumer and be sure to ask your loan officer for a Loan Estimate (more on that below) in order to have a complete, holistic view of all charges.
APR and Loan Estimate
While you can simply compare APRs from different lenders of the same loan types to help guide your decision, you can also invest a little time into looking over the government-mandated Loan Estimate document that all lenders are required to furnish. This is a wonderful opportunity to gain true visibility into the various terms and expenses of your loan. Important components of this document include:
- Projected monthly payments including your portion of the principal, taxes, insurance and assessments
- Estimated closing costs
- A full list of expenses featuring YES and NO answers to salient questions such as “Can loan amount and interest rate increase after closing?” as well as questions about prepayment penalties
- Information on services that you can shop for (i.e., title insurance) and those you cannot shop for (i.e., appraisals, etc.)
- Clearly articulated APR
- Information on how much of the principal you will have paid off in 5 years and how much principal plus interest, mortgage insurance and other costs you will have paid off in five years
Taken together and used wisely, the information in your Loan Estimate can provide valuable insight and transparency into APR and an accurate accounting of the costs lenders will charge you given your specific loan product.
15-year, 30-year and ARM loans
If you want to compare different APRs, it’s important that you compare the same type of loan (Conventional, FHA, VA, USDA) and the same loan product. Think of the loan product as the length or rate structure of the loan (15- or 30-year loans, for example). It’s a significant factor when comparing different APRs.
A conventional mortgage on a $300,000 home, for example, can be paid off in several different ways including a 15-year fixed-rate loan, a 30-year fixed rate loan and various types of adjustable rate mortgages (ARM).
Generally speaking, shorter-term loans have lower interest rates than longer-term loans. That’s true for a 15-year fixed loan. However, because you are paying off the principal in half the time, the monthly payments will be noticeably higher.
A longer loan product like a 30-year loan has the opposite consideration. Smaller monthly payments but higher APR. Most borrowers prefer this option.
And ARM loans? These can be advantageous within the right market conditions. But it’s a gamble. In unstable periods, rates can drift upwards causing your interest rate to also ascend and create higher monthly payments. There are built in caps, but the end result can still create financial headaches for unprepared borrowers.
Essentially, it’s a tradeoff. Only you know what kind of payment schedule is appropriate for your financial situation.
At the beginning of your home search, it can be helpful to leverage tools such as an affordability calculator for a clearer portrait of personal finances and true indication of what you’re comfortable paying—in the long run and each month.
It can be useful to think of APR as the interest rate on your loan—plus charges such as origination fees and closing costs. Certainly, interest rate comprises the majority of the APR, but it’s the additional charges included that make APR a useful indicator of future payments when comparison shopping for home loans.
Whether you’re buying for the first time or looking to refinance, there’s no substitute for conducting some robust due diligence in order to make an informed decision on who to trust with your mortgage. Understanding how both the underlying interest rate and APR are calculated is key to obtaining an affordable home loan.
*This is not a complete list of all APR-related costs. Please check with your lender for a full list of all costs included in APR.