It’s time for another mortgage match-up: “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, possibly in smaller print.
But why? Well, one is the mortgage rate, which is the interest rate you’ll pay every month on your mortgage (assuming you actually qualify).
APR = Annual Percentage Rate
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.
The APR is a measure used to determine the true cost of a loan. Instead of a bank or mortgage lender telling that your rate is 6.5% with $8,000 in fees, they’ll just say the annual percentage rate is 6.87% with those fees factored in.
The annual percentage rate was essentially created to prevent lenders from not disclosing fees that went into a loan to make the rate appear better than the competition.
For example, an unscrupulous lender could advertise a rate well below the competition while downplaying the associated fees, making their offer look unbeatable. In reality, it could be a terrible deal.
The APR addresses this issue by including most of the fees lenders charge during the loan transaction. These fees are then rolled into the interest rate to come up with the APR.
However, it’s still not sufficient to choose a mortgage based on APR alone, because lenders do not include all the fees associated with your loan transaction.
You might see something like “fees included in APR” next to the rate. Pay attention to what’s actually included. The APR also assumes a loan will be paid off at the end of the full term, whether it be 15 or 30 years.
Most homeowners hold onto their mortgages for a significantly shorter period of time, which will completely throw off the actual APR. Additionally, APR is not an effective measure between different products, only like products because of APR’s time dependency.
Mortgage APR a More Accurate Representation of Loan Cost
As noted, 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 basic 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 on mortgage rate “X” 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 inventory 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.
The following fees are usually included in mortgage APR:
– Discount points/broker fee/yield-spread premium
– Origination fee
– Mortgage points
– Prepaid interest
– Processing fee
– Underwriting fee
– Document drawing fee
– Mortgage insurance
Notice that most of the fees above are charged by the lender, not a third-party.
The following fees are usually not included in mortgage APR:
– Title fees
– Escrow fees
– Notary fees
– Recording fees
– Credit report
– Appraisal report fee
– Appraisal review fee
– Home inspection fees
– Pest inspection fees
– Doc prep fees
– Attorney fee
– Hazard insurance
Notice that the latter group are third-party fees, which aren’t from the lender itself. They include title/escrow company fees, home inspections, and so on.