By Libby Christoules, Flyhomes Mortgage
As we’ve talked about before, focusing on interest rates when choosing a lender can be a flawed strategy. One lender may offer you an interest rate of 3.25% and another may offer you an interest rate of 3.99% for the same loan scenario. While you might be tempted to choose the lower interest rate, you’re only seeing a small part of the picture. You don’t yet see how much either of those rates will end up costing you.
This is where the Annual Percentage Rate, or APR, comes into play. While the interest rate dictates how much interest you’ll pay and what your monthly payment will be, the APR reflects the total cost of the mortgage.
APR includes fees and costs associated with obtaining the loan in addition to the interest rate, all expressed as an annualized rate.
APR is the best way to compare loan quotes
Any time your lender advertises or quotes an interest rate and monthly payment amount, they are also required to disclose to the APR (whether or not they are breaking out the closing costs for you).
Fees that are included in the APR may include: origination and discount points, processing and underwriting, escrow fees, and PMI. Since these fees can vary from lender to lender, the APR is a great gauge for how expensive a loan can be. Assuming you’re comparing two loans with the same terms and interest rate, the higher the APR, the more you’re paying for that loan.
Disclosure also helps to hold your lender accountable — your lender is not permitted to increase your APR by more than 0.125% without providing at least 3 days advance notice. This is meant to eliminate any cost surprises when you close on your mortgage loan.
How is APR calculated?
Imagine you are trying to borrow $500,000 for the purchase of your new home. In order to obtain the loan, it’s going to cost you $5,000 in finance charges or closing costs. That means you are really only borrowing $495,000 while your monthly payment is calculated based on the full $500,000 loan.
The APR is a measure of your monthly payment compared to the net amount you are borrowing after finance charges.
Step 1: Use your loan amount and interest rate to determine your monthly payment. So: if your loan is $500,000 at 4.000% interest over 30 years, your monthly principal and interest payment would be $2387/month.
Step 2: Using the same monthly payment and net amount financed, work backwards to obtain your APR. With a $2387/month payment and truly only borrowing $495,000, your actual cost is at a rate of 4.083%—this is your APR.
With fixed rate mortgages, because the interest rate stays constant for the entire life of the loan, the only other factor taken into consideration are your finance charges paid upfront and PMI (if required).
With adjustable rate mortgages (aka ARM’s), the APR will also take into account future interest rate adjustments. Because these exact adjustments are unknown at the time you are taking out the mortgage, the APR takes into consideration the worst-case outcome, assuming your interest will increase to the maximum “cap” allowed under that program each year.
How to use APR to make your decision
The lower your APR, the less you pay in terms of both interest and fees for the mortgage.
If you plan to keep the home for a long time, it generally makes sense to take the loan with the lowest APR as it means your long-term cost will be the lowest.
If you plan to keep the home for only a short time, pay extra attention to the gap between the interest rate and the APR. A large gap may indicate a high amount of up front costs due at closing, which means you may not be the best route given that you plan to sell in the short term.
Want to talk about a mortgage loan?