Itâs common for homebuyers to focus on interest rates while shopping for a mortgage, however, thereâs another number that might even be more important.
While a low interest rate is appealing and directly impacts your monthly mortgage payment, itâs also important to look at each loanâs annual percentage rate, which provides a clearer picture of how much the loan will cost you when other fees are factored in.
The APR includes the interest rate as well as other fees and costs, and is expressed as a percentage. The interest rate only includes interest paid to the bank.
An annual percentage rate (APR) is a broad measure of what it costs to borrow a loan. It includes the interest rate as well as other fees and costs.
The difference between an APR and an interest rate is that an APR gives borrowers a truer picture of how much the loan will cost them. Although an APR is expressed as rate just like interest, it is not related to your monthly payment â which is calculated using only the interest rate. Instead, an APR reflects the interest rate along with fees and other one-time costs a borrower will pay to get a mortgage.
âYou can find a mortgage that has a 4% interest rate, but with a bunch of fees, that APR may be 4.6% or 4.7%,â said Todd Nelson, senior vice president of strategic partnership with online lender LightStream. âWith all of those fees baked in, they are going to swing the interest rate.â
For example, one lender may charge no fees, so the loanâs APR and interest rate are essentially the same. The second lender may charge a 5% origination fee, which will increase the APR on that loan.
Lenders calculate an APR by adding fees and costs to the mortgage interest rate and creating a new price for the loan. Letâs look at an example:
A lender approves a $100,000 mortgage at a 4.5% interest rate. The borrower decided to buy one discount point, which costs $1,000, to get the 4.5% rate (a discount point is a fee paid to the lender in exchange for a reduced interest rate). The loan also includes $900 in fees, which are being financed in the mortgage.
With the fees and costs mentioned above added to the loan, the adjusted starting mortgage balance becomes $101,900. The monthly payment (which consists of the principal plus interest) is then $516.31 with the 4.5% interest rate, compared with $506.69 if the balance had remained at $100,000.
To find the APR, the lender returns to the original loan amount of $100,000 and calculates the interest rate that would create a monthly payment of $516.31. In this example, that APR would be approximately 4.661%.
APRs will vary between lenders, as no two lenders are exactly alike. Some may offer competitive interest rates, but then tack on expensive fees and costs. Lenders with the same interest rate and APR probably arenât charging any fees on that loan, and lenders that offer APR and interest rates that are close are likely charging a lower amount of fees and extra costs.
In short, APR gives you a way to compare two lenders offering the same interest rate so you make the smartest possible decision about your mortgage.
APRs change as interest rates fluctuate, but theyâre more impacted by lender costs and fees. Below are some of the common charges that affect APRs:
Closing costs that arenât commonly in an APR calculation are notary fees, credit report costs, title insurance and escrow services, home appraisal, home inspection, attorney fees, document preparation and recording fees.
Because an APR includes a loanâs interest rate, rising interest rates will increase the APR for several products including mortgages, auto loans and other types of loans and credit.
A mortgage interest rate is the rate a lender uses to determine how much to charge a homebuyer for borrowing money. Mortgage rates can either be fixed or adjustable.
Fixed mortgage rates donât change over the life of a loan. For example, if you take out a 30-year loan at a 4.25% interest rate, that rate will stay the same â regardless of changes in the economy and market index â until the loan is paid off.
On the other hand, adjustable-rate mortgages (ARMs) will fluctuate as market conditions change after an introductory period, often set at five or seven years. That means your interest rate could go up or down depending on the economy, which will in turn raise or lower your mortgage payments.
ARMs often start with a lower interest rate than a fixed-rate mortgage, but can dramatically increase after the intro period ends.
If you are considering an ARM, itâs important to talk to lenders first about what an adjustable rate could mean for your monthly mortgage payments. Be sure to ask the following questions:
Donât be surprised if a lenderâs mortgage rate is higher than what was advertised. Each loanâs interest rate is primarily determined by market conditions and by the borrowerâs financial health. There are several factors that help determine your rate, including:
Below, we use LendingTreeâs mortgage calculator to illustrate how interest rates can affect monthly mortgage payments.
(Principal and interest)
|Interest paid after five years||$8,651.39||$9,517.96|
As shown above, an interest rate increase of even less than a half-percent could bump your monthly payment up by nearly $52, and your interest paid over the first five years by more than $800.
The annual percentage rate on an adjustable-rate mortgage wonât apply for the life of the loan, since the interest rate and monthly payment will change as the economy fluctuates. The APR only applies during the loanâs initial fixed-rate period, and no one can predict how much the rate will increase in the years that follow.
For example, a 7/1 ARM has a fixed interest rate for the first seven years that is determined by the market conditions on the day the loan was closed. After seven years, the interest rate will adjust annually, based on the movement of the index the ARM is tied to, which is commonly the one-year LIBOR.
The new rate likely wonât be the same as it was when the loan was originated. Mortgage rates fluctuate daily, and no economic forecaster can accurately predict how the index will change in the future.
While lenders often push their low interest rates when they advertise loans, Nelson said itâs vital that consumers check APRs when shopping around, and pay attention to how loan advertisements are worded. Lenders may advertise âno hidden fees,â he said, but that might just mean there are other fees that simply arenât hidden.
âLook for a lender thatâs transparent about disclosing all of those fees,â Nelson said.
Ask for clarity about any cost estimates you donât understand, and try to negotiate lender fees where possible.
This article contains links to LendingTree, our parent company.
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