If you're like most consumers, there's one number that you obsess over when applying for a home loan: the mortgage rate that lenders quote you. But there's another number that is more important, and that gives you a better idea of how expensive a mortgage loan really is: the annual percentage rate or APR.
Don't be upset if you have no idea what APR is or what it measures. You're far from alone. But if you're being a smart consumer and shopping around with different lenders for the most cost-effective mortgage loan, you’ll need to educate yourself on APR, and quickly.
If you don’t, you might take out a loan with a lower interest rate that actually costs you more over the long-term than one with a rate that’s slightly higher.
"The APR is the best way we have to do apples-to-apples comparisons of different mortgage products," said David Reiss, professor of law and director of the Center for Urban Business Entrepreneurship at Brooklyn Law School in New York City. "Numerous studies have demonstrated that many Americans are poor at doing personal finance calculations. There is no easy fix for this situation, although the APR can be a very helpful tool for people as they navigate the complicated process of getting a mortgage."
The APR formula
What is the difference between APR and a mortgage’s interest rate? Interest rate tells you how much your lender is charging you to borrow money. APR tells you more: it starts with the interest rate attached to your loan but also accounts for any fees the lender is charging you.
APR includes such fees as the points you pay for a lower interest rate and the closing costs that lenders will charge to close your loan. APR, then, is always higher than your interest rate. And it’s also a more accurate measure of how much your loan costs.
After you apply for a mortgage, the lender is required to provide you an official Loan Estimate within three days. This form lists the estimated costs of your mortgage loan, including the interest rate, closing costs and the APR.
When you are comparing offers from more than one mortgage lender, then, it’s better to look at your APR than it is to rely solely on your interest rate.
If one lender is charging you an interest rate of 3.75 percent while a second is charging 3.50 percent, you might think the second mortgage loan is the cheaper option. But maybe the second lender is charging you higher fees, which the APR will show. So the first loan may be the less expensive option.
Why APR matters
Joseph Pohl, digital marketing specialist for Residential Acceptance Corporation in Tampa, Florida, said that APR is an important number for borrowers shopping for fixed-rate mortgages or investigating a cash-out refinance.
That’s because APR provides a more accurate picture of what a loan will actually cost you. If you are considering a refinance, for instance, 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 different lenders to help choose the one that will provide you with the biggest monthly savings at the lowest cost.
Pohl said that the math behind APR is fairly complicated. Lenders amortize their fees out over the life of a loan as if they were additional payments. You don’t really have to understand what that means. You just need to understand that a lower APR means a more affordable loan.
“Basically, the APR represents a one-time charge for the lender’s prepaid finance charges required to close the loan,” Pohl said.
Why APR isn’t perfect
Joe Parsons, senior loan officer with PFS Funding in Dublin, California, said that the fees typically included in APR include processing and underwriting charges, document-preparation fees, points that consumers pay to get a lower interest rate, mortgage insurance, escrow fees and wire fees.
He agrees that APR is a useful tool for consumers. But it's not a perfect one, he said. That's because when lenders calculate your APR, they assume that you'll keep the loan for its entire term and that your loan's interest rate will never change.
"Do you really think you will have that loan for the full 30 years?" Parsons asked. "No? Then the APR calculation will be incorrect for your purposes. Are you considering an adjustable-rate mortgage? If you are, the APR is even less useful, since the calculation assumes that the interest rate never changes."
Brian Martucci, a loan officer with Baltimore-based 1st Mariner Mortgage, said that consumers shouldn't rely solely on APR, or any one number, when shopping for a mortgage loan.
"The thinking is that consumers can simply ask lenders for the APR and can then quickly shop by analyzing this one number," Martucci said. "But things are not that simple."
What APR doesn’t include
APR typically does not include, for instance, the costs charged by title insurers, home inspectors and appraisers.
This doesn't mean that APR isn't important. It is. And by comparing APRs, borrowers will get a better idea of which lenders are charging them more to originate their loans. But Martucci said that it is important, too, for lenders to look at the individual fees that lenders are charging for everything from underwriting to preparing documents. All of these fees are spelled out on the Loan Estimate that you will receive.
Look, too, at the fees being charged by third-party providers such as title insurance companies, appraisers and home inspectors. Your lender does not control these fees, but you can shop around for cheaper title insurance and inspections.
Only by taking this holistic approach, including studying APR, will you increase your odds of taking out the most affordable mortgage loan.