Mortgage match-ups: “Mortgage rate vs. APR”
If you’ve seen a certain mortgage rate advertised lately, you may have noticed a second, similar percentage adjacent to or below that rate.
But why? Well, one is the mortgage rate, which is the interest rate you’ll pay every month (assuming you actually qualify).
And the other is the Annual Percentage Rate, or APR, which is the interest rate factoring in certain loan costs, such as processing, underwriting, loan origination fees, mortgage insurance premiums, and so on.
Mortgage APR a More Accurate Representation of Loan Cost
The mortgage APR is basically the true cost of the loan, or at least a bit more accurate than a simple interest rate. I’ll explain why with a simple example.
Let’s look at an example:
Mortgage Rate X: 4.50%, 4.838% APR
Mortgage Rate Y: 4.75%, 4.836% APR
The advertised mortgage rate “X” is 4.50%, but requires that two mortgage points be paid – it also has $2,000 in additional closing costs, which pushes the APR to 4.838%.
Meanwhile, advertised mortgage rate “Y” is offered with no points and just $1,000 in closing costs, so the APR is 4.836%, just below that of mortgage rate “X.”
So even though one advertised mortgage rate may be lower than another, once closing costs are factored in, it could actually end up being higher.
That’s why it’s very important to consider both the rate and the APR.
At the same time, the monthly mortgage payment on mortgage rate “X” will be cheaper each month because of the lower interest rate.
For example, if the loan amount in our example is $200,000, the monthly principal and interest payment would be $1,013.37 versus $1,043.29 on mortgage rate “Y.”
So if you’re more concerned with your payment as opposed to loan cost, you might still be interested in the slightly more expensive option.
Of course, the goal should be both a low APR and a lower mortgage rate, which you might be able to achieve by taking the time to shop your rate.
Mortgage APR Limitations
Though it’s extremely important to know both the mortgage rate and the APR, there are limitations to this calculation.
As noted, some costs aren’t included in the APR, and banks and mortgage lenders calculate APR differently, so it’s not always simple to get an apples-to-apples comparison.
However, many third-party costs are pretty similar, so it might not matter too much. You just may want to take note of these costs to ensure they aren’t exorbitant or far above what other banks are charging.
Additionally, the mortgage APR assumes you’ll hold the loan for its full amortization, but most people sell or refinance long before loan maturity. That can change the picture quite a bit.
Put simply, high cost loans held for a short period will actually result in a higher APR than advertised, because the costs aren’t spread over the full term.
Watch Out for APR on ARMs
This is essentially because lenders calculate the fully indexed rate (once it adjusts) by combining the margin and associated mortgage index.
And since mortgage indexes are so low at the moment, they assume you’ll have a lower rate once the loan adjusts, which may or may not be the case. A lot can change in a few short years and the fully indexed rate may indeed be higher.
Don’t bank on the fully indexed rate being lower, because rates are historically close to rock-bottom and probably won’t stay that way for long.