What Is APR and How Does It Affect Your Mortgage?
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Annual percentage rate, or APR, reflects the true cost of borrowing. Mortgage APR measures costs including the interest rate, points and fees charged by the lender. APR is higher than the interest rate because it encompasses all these loan costs.
Here’s a primer on the difference between APR and interest rate, and how to use it to evaluate mortgage offers.
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Interest rate vs. APR
Knowing the APR helps you compare offers as you choose the best mortgage lenders to work with. The interest rate is the percentage that the lender charges for lending you money. The APR reflects the interest rate plus the fees you paid directly to the lender or broker or both: origination charges, discount points and any other costs. It is calculated using a formula found in Appendix J of Regulation Z, also known as the Truth in Lending Act.
Mortgage fees add to the cost of the loan, and APR takes them into account. That's why APR is higher than the interest rate.
» MORE: Calculate your mortgage APR
APR comparison
APR is a tool that lets you compare mortgage offers that have different combinations of interest rates, discount points and fees. Comparing APRs is most useful when you plan to keep the loan for more than five or six years. That's because the APR calculation assumes that you'll keep the loan for its entire term. But not every borrower does that. Most people sell the home or refinance the loan before it's paid off.
As a hypothetical example, let's say you're comparing two offers on a $200,000 loan for 30 years:
Loan A: You could borrow $400,000 with an interest rate of 6.5%, paying a 1% origination fee of $4,000, with no discount points and $2,000 in other fees. Total fees: $6,000.
Loan B: You could buy a discount point to reduce the interest rate. In this offer, you could borrow $400,000 with an interest rate of 6.25%. You would pay a 1% origination fee of $4,000, another $4,000 for one discount point and $2,000 in other fees. Total fees: $10,000.
Bottom line: Loan A has a higher interest rate and lower fees, while Loan B has a lower interest rate and higher fees, so how do you compare them?. As you see in the table below, Loan B has a lower APR, which means that you would end up paying less over the 30-year life of the loan when you include principal, interest and upfront fees.
Loan A | Loan B | |
|---|---|---|
Interest rate | 6.50% | 6.25% |
Lender fees | $6,000 | $6,000 |
Discount point | None | $4,000 |
APR | 6.64% | 6.49% |
How long you have the loan matters
The loan with the lower APR costs less over the mortgage's 30-year term. But what if you plan to keep the loan for less than that?
Loan A, without discount points, costs less in the first five years and one month. Loan B, with discount points, costs less when you have the loan for five years and two months or longer.
Loan A total costs | Loan B total costs | |
|---|---|---|
3 years | $97,018 | $98,663 |
5 years | $157,696 | $157,772 |
5 years, 1 month | $160,225 | $160,235 |
5 years, 2 months | $162,753 | $162,698 |
10 years | $309,393 | $305,544 |
30 years | $916,178 | $896,633 |
In this example, the break-even period for paying points is five years and two months, meaning it will take that long to see the savings from paying those points. Not every loan has the same break-even period, which varies depending on the loan amount, interest rates and cost of fees and discount points.
APR is useful for comparison in some cases, but not all. Fortunately, there's another way to compare loan offers. It's in a section of the Loan Estimate that calculates how much the loan will cost in the first five years.
Using the Loan Estimate to compare mortgage offers
When you apply for a mortgage, the lender is required to give you a three-page document called a Loan Estimate. Page 3 of the Loan Estimate has a "Comparisons" section that lists not only the APR but also how much the loan will cost in the first five years: fees to get the loan, plus 60 months of principal, interest and any mortgage insurance.
In the earlier example, Loan A (6.64% APR) would cost $157,696 in the first five years, and Loan B (6.49% APR) would cost $157,772. So Loan A would cost $76 less in the first five years. Even though Loan A has a higher APR, it would be the better deal if you kept the loan for only five years.
When you get multiple loan offers, line up the "Comparisons" sections of the Loan Estimates side by side to help you decide.
» MORE:Compare mortgage rates
