Shopping for a mortgage can be confusing. Borrowers have to sort through a mix of interest rates, fees, points and all the rest to try to figure out what's the best deal.

The figure called the APR is supposed to help make that easier. But most borrowers don't understand just how it works or how you're supposed to use it.

APR stands for Annual Percentage Rate. Put simply, it's a way of expressing the actual cost of a mortgage in terms of an interest rate, a rate that's supposed to be a more accurate reflection of the loan's true cost than the stated mortgage rate.

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

The APR must be included on any advertisement that offers a mortgage rate for a given loan. So it provides a quick way to sort through competing loan offers at a glance to get a sense of how they compare to each other. 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 when you apply for a mortgage, as well as on the Truth in Lending Statement you receive before closing the loan.)

How APR works

The way APR is calculated is that it's the interest rate that, charged on the base loan amount, would produce the same monthly payment as the actual mortgage rate would if you rolled all the various fees into the loan. It's best explained through an example.

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

If you roll that $6,000 into the loan, you'd be borrowing $206,000 at 4.75 percent interest, which would raise 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 which would charge 4.65 percent interest but with $10,000 in fees. Adding that onto the base loan gives a total of $210,000, which at 4.65 percent over 30 years produces a monthly payment of $1,082.84. To get the same monthly payment on $200,000, the interest rate would be 5.075 percent, which is the APR.

So you can see the first loan appears to be a better deal, even though it has a higher interest rate.

The limitations of APR

A few things to note about APR. First, it 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 up front than rolling $10,000 in closing costs into a mortgage that will cost you 4.65 percent. In effect, you're only paying 1 percent for the money (lost earnings) compared to 4.65 percent (actual interest paid).

Second, the APR assumes you'll pay off the loan through normal amortization, and won't refinance it or pay it off early (such as if you sell the home in a few years). That's going to affect the math. 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 awhile for the benefits of a lower interest rate to balance out the cost of higher fees.

Third, APR doesn't work very well with adjustable-rate mortgages (ARMs), because the rates on those start changing before you ever get close to paying the loan off, and ARMs vary on how much their rates change. So keep that in mind as well.

But even though it's not perfect, APR is still a very valuable tool to use when shopping for a mortgage. A loan with a significantly higher APR than competing offers should send up a red flag. Otherwise, use a mortgage calculator to run all the numbers and try to figure out what loan makes the most sense for you.

Published on May 18, 2009