Using Annual Percentage Rate (APR) to More Accurately Assess Mortgage Costs

Shopping for a mortgage can be confusing for those unfamiliar with the process. Borrowers have to sort through what kind of loan they want and then figure out a mix of interest rates, fees, and points to determine the best deal.

One of the ways this is supposed to be easier is by lenders stating the Annual Percentage Rate (APR) of a loan you’re being offered. That is different than a simple interest rate and should give you a more accurate reflection of the loan’s true cost than only factoring in the mortgage rate percentage.

APR makes it easier to figure out an apples-to-apples comparison so that you can focus on other parts of the home-buying process.

Although it’s not foolproof, and you sometimes have to consider other factors, it is a great tool to help cut through the clutter and determine the bottom-line cost of a mortgage.

APR Defined 

Many people need clarification on the difference between APR and interest rates.

In simple terms, the interest rate tells you how much your lender charges to borrow money. APR tells you more because it starts with the interest rate on a loan but also accounts for fees the lender is charging.

APR is often defined as the total cost of a loan expressed in terms of an interest rate. For example, if your closing costs are $8,000, the APR represents the interest rate that would generate an additional $8,000 in charges over the life of the loan, over and above your official mortgage rate.

The APR includes fees and points you pay for a lower interest rate and the closing costs lenders will charge to close your loan. That means APR is always higher than your interest rate. And it’s also a more accurate measure of how much your loan costs.

When comparing offers from more than one mortgage lender, it’s more accurate to look at your APR than relying solely on your interest rate.

You don’t need to know how to calculate APR or understand the APR formula to use it to get the best deal. In most cases, the loan with the lower APR will be less expensive. 

If you are considering refinancing, APR can help you determine whether the monthly savings on your mortgage payment are worth the cost of refinancing. You can also use APR to compare refinance offers from several lenders to help choose the one that will provide you with the biggest monthly savings at the lowest cost.

APR Legal Disclosures

It’s a helpful tool because lenders often offset a low advertised mortgage rate by charging higher closing costs. A higher mortgage rate may be a better deal with lower fees. The APR is intended to help you sort that out.

The APR must be included in any advertisement offering a mortgage rate for a given loan. It creates a quick way to sort through competing loan offers at a glance to understand how they compare. Generally speaking, the lower the APR, the lower the total cost of the loan.

The APR must also be featured prominently on the Good Faith Estimate you receive within three days when you apply for a mortgage and on the Truth in Lending Statement you receive before closing the loan.

Examples of How APR Works

Consider two loans, both for $200,000 at 5% interest. 

Assume that the first loan has no fees or points paid, so the borrower is simply borrowing $200,000 at 5% interest. 

On the second loan, assume that the borrower is paying $5,000 in fees and points, which are included in the $200,000 balance the borrower owes. So, in reality, the borrower is getting a $195,000 loan, with a $5,000 charge added.

The APR takes into account this $5,000 charge in figuring the cost of borrowing $195,000, which is actually available for the borrower to use. 

The $5,000 is spread over the loan term and rolled into the interest rate. With that in mind, the borrower is paying an APR of 5.218% to borrow $195,000 over 30 years, even though the actual terms of the loan are $200,000, including fees at an annual rate of 5%.

A borrower can pay $5,000 in fees upfront at closing to get the terms of the first deal. However, since money can be tight when buying a home, buyers often delay paying this by rolling into their loan amount.

Here’s another example.

Suppose you’re borrowing $200,000 on a 30-year fixed-rate mortgage at 4.75%. That gives you a monthly mortgage payment of $1,043.29. Closing costs typically range from 2-5% of the loan amount, so let’s say you’re charged 3% or $6,000 in fees on this loan.

If you roll that $6,000 into the loan, you’re borrowing $206,000 at 4.75% interest, raising your monthly payment to $1,074.59. To get the same monthly payment on $200,000 (the actual loan amount), you’d need an interest rate of 5.008%, which is the APR.

Now consider another loan offer that would charge 4.65% interest but with $10,000 in fees. Adding that onto the base loan gives a total of $210,000.

At 4.65% over 30 years, that equates to a monthly payment of $1,082.84. To get the same monthly payment on $200,000, the interest rate would be 5.075%, which is the APR.

APR Limitations

APR. doesn’t necessarily reflect the true cost of the extra fees and charges. It only expresses them in terms of the mortgage rate itself.

For example, if you have an extra $10,000 in a CD or savings account that is only earning 1 percent, you’re better off using that to pay the costs upfront than rolling $10,000 in closing costs into a mortgage that will cost you 4.65%. In effect, you’re only getting a 1% return on your money compared to paying 4.65% when those costs are rolled into the loan.

Second, the APR assumes you’ll pay off the loan through normal amortization and won’t refinance it or pay it off early if you sell the home. Those variables do affect the math. If you think you might sell or refinance within 7-10 years, a higher rate and lower fees loan might be better. 

Generally speaking, it’s better to have lower fees if you expect to sell or refinance before the loan is paid off, since it takes a while for the benefits of a lower interest rate to balance out the cost of higher fees.

A loan with a significantly higher APR than competing offers should raise a red flag. Otherwise, use a mortgage calculator to run all the numbers and determine the loan that makes the most sense.

 What About Adjustable Rate Loans?

The APR can be used to compare offers on adjustable rate mortgages, even though the rates fluctuate over time. 

For adjustable rate loans, APR is calculated assuming you’ll have the mortgage for the entire term and simply pay the new rate whenever it resets. Because no one can predict what interest rates will do in the future, the calculation simply assumes the base rate or rate index that rate resets are based on will remain unchanged.

The calculation depends on how much the resets vary from the base rate.

That may be a little confusing, so discussing this with a loan officer who can fully explain the concept if you’re leaning toward an adjustable rate loan is best.

What APR Doesn’t Include

APR usually does not include the costs charged by title insurers, document preparation, various underwriting costs, home inspectors, and appraisers. In most cases, those charges are paid differently, although you can see if your lender will also roll those costs in, which sometimes happens.

Your lender does not control these fees, but you can shop around for cheaper title insurance and inspections. Also, all those fees are spelled out on the Loan Estimate you will receive.