When you apply for a mortgage, you’re certain to come across the term APR, or annual percentage rate. You may be asking yourself: What is APR and why is it important?
APR is used to evaluate the true cost of borrowing money. It includes the interest rate offered on your mortgage, as well as points, mortgage origination fees and other costs associated with obtaining a loan. You’ll notice the APR is usually higher than your interest rate because it encompasses all these loan costs.
The difference between APRs and interest rates, and the other finer points of borrowing money, can be a bit confusing at first glance. Here’s a primer on how APR is calculated and how it factors into your monthly mortgage payments.
» MORE: An average APR is often 0.20%-0.25% higher than your interest rate. Calculate your mortgage APR
What’s the difference between APR and interest rates?
Understanding these items is crucial when choosing the best mortgage lenders to work with on your loan. Here are five terms you need to know:
- Compound interest: Interest that’s added on the initial principal of the loan and on the previously accumulated periods of interest. Simply put, it’s interest on interest.
- Nominal interest rate: The amount that’s charged on your loan balance in a given period of time.
- Nominal APR: The nominal interest rate multiplied by the number of periods in a year.
- Effective interest rate: Expressed annually, it accounts for compounding, but not fees.
- Effective APR: This typically accounts for both compounding interest and any fees charged on the loan.
To review, the interest rate is the rate used to calculate the amount of interest charged each period. When multiplied by the number of periods in the year, you get your nominal APR. The effective interest rate includes compounding, while the effective APR includes both compounding and fees.
Using APR to evaluate mortgages
You might be wondering how all of these numbers factor into your mortgage payment. Generally speaking, the higher the APR, the higher the payments over the life of your home loan.
Let’s look at two loans and see how the numbers play out over the course of the loans. The first is a 30-year, fixed-rate $300,000 mortgage with a 6% APR. You would pay no fees upfront. Your monthly payment would be $1,798.65. Over the course of 30 years, the total interest paid would be $347,515, for a total repayment amount of $647,515.
If, however, you took out the same mortgage and paid $40,000 in one-time fees upfront, you would have a 4% APR and end up paying $1,432.25 for 360 regular payments. At the end of 30 years, you’d have paid $215,607 in interest, for a total cost of $555,607. Three decades in, paying the upfront fee was clearly a good idea.
But what happens if, after four years, you decide to sell your house? Is the lower APR, one-time-fee mortgage still the best deal? Here are graphs that shed light on the answer. With the 4% APR plus the $40,000 fee, you’ll pay $16,109 more for your loan if you move after four years than you would have if you had chosen the loan with the 6% APR.
In other words, if you plan to stay in your home less than the full loan term, using APR isn’t the best way to gauge the total cost of your mortgage. You’ll want to evaluate all of the facets of your loan — interest rate, APR, fees and closing costs, as well as the loan term and type — to find the product that makes most financial sense for your individual situation.
» MORE: Customize your APR scenario with NerdWallet’s amortization schedule calculator
What About ARMs?
Keep in mind that adjustable-rate mortgages are a whole different ballgame. Be especially careful when considering these types of loans, as the initial interest rate is often low but can expose you to much higher rates later on.
If you take out an adjustable-rate mortgage and stay in a home for only a few years, you could save a lot of money with the lower rates. If you plan to stay put longer than five years, though, you might consider a longer-term home loan with stable, fixed monthly payments.
Updated Aug. 25, 2016.