When lenders advertise mortgage rates, or when you apply for a loan, they are required to inform you of the interest rate as well as the annual percentage rate, or APR. The APR is intended to help consumers shop for loans by making them easier to compare by measuring the net effective cost of borrowing.
The APR is the total yearly cost of the mortgage expressed as a percentage of the loan amount. The APR takes into account the costs home ownership when getting a loan, including interest, lender charges, points and mortgage insurance. The APR will be slightly higher than the interest rate, typically around 0.25% higher.
Why APR Can Be Misleading
There is no standardization for what must be included in APR calculations. This means some lenders may include some fees in the APR, while others are separate. Appraisal fees and title fees are almost always excluded from the APR calculation. Some settlement charges do not deviate greatly between lenders, such as taxes, but other closing costs can vary wildly. In these cases, the APR will give no indication as to which fees are too high.
APR is also calculated on the assumption that the borrower will keep the loan for the full term and never sell the home early, pay off the loan early or refinance. It does not consider inflation, either. This means that closing costs will be amortized over the whole loan term. If you are getting an adjustable rate mortgage (ARM), the APR will be fairly meaningless because there is no predicting what the rate will be when the loan resets.
Is the Lowest APR the Best Loan?
The lowest APR does not automatically signify the best deal on a mortgage, unless you plan to keep your mortgage for the full term and never refinance or make extra payments. Otherwise, the upfront costs of the loan will be spread over a shorter amount of time, which changes the cost of the loan.
Here is an example of APR:
- Borrow $100,000 at 5% with a 30-year term and your payment will be $537. If one lender closes this loan for $1,000 and the other costs $4,000, they will have different APRs. In the first loan, the APR will be 5.09%, while the second loan will be 5.35% APR.
- If the loan's term is changed from 30 years to 5 years because the home is sold, the APR jumps from 5.09% to 5.41% in the first example.
Consider Other Terms Along with the APR
The APR of a loan is an important comparison tool, but it cannot be relied upon completely. You should understand the true cost of your mortgage before committing, which involves analyzing the Good Faith Estimate (GFE) you receive from the lender. The GFE will list all fees you will be charged, including those that are not included in the APR. Lenders must provide this information without a commitment from you.
Because a mortgage is most likely the largest financial liability you will ever accept in your life, make sure you are not paying more than you need to. You are typically going to pay fair market value for your home, but your financing is something you want to make sure you are getting the best deal on. This can save you thousands over the course of your payments. Get educated and know financing options.