When you apply for a mortgage, you’re certain to come across the term APR, or annual percentage rate. APR is used to evaluate the true cost of borrowing money. It includes the interest rate, points, mortgage origination fees and other costs associated with obtaining a loan. The APR is usually higher than the interest rate because it encompasses all these loan costs.
Here’s a primer on the difference between APR and interest rate, how APR is calculated and how to use it to evaluate mortgage offers.
APR vs. interest rate
Understanding these items is crucial when choosing the best mortgage lenders to work with. The interest rate is the percentage that the lender charges for lending you money. The APR reflects the interest rate plus the fees you paid directly to the lender or broker or both: origination charges, discount points and any other costs. Those fees add to the cost of the loan, and APR takes them into account. That’s why APR is higher than the interest rate.
» MORE: Calculate your mortgage APR
Should I use APR or interest rate?
APR is a tool that lets you compare mortgage offers that have different combinations of interest rates, discount points and fees.
As a hypothetical example, let’s say a lender offered you two choices for a $200,000 loan for 30 years:
- Loan A: You could borrow $200,000 with an interest rate of 4.25%, paying a 1% origination fee, no discount point and $1,000 in other fees, for $3,000 in estimated total fees.
- Loan B: You could borrow $200,000 with an interest rate of 4%, paying a 1% origination fee, 1 discount point and $1,000 in other fees, for $5,000 in estimated total fees.
Loan A, with a higher interest rate but lower fees, has an APR of 4.38%.
Loan B, with a lower interest rate but higher fees, has an APR of 4.21%.
Loan B has a lower APR, which means that it has lower total costs over the 30-year life of the loan when you include the upfront fees. But what if you don’t plan to keep the home (and the loan) for 30 years? In that case, comparing APRs gives you an incomplete picture. Here’s why: A loan with a lower APR might cost less over the entire 30 years, but it might cost more in the first five years.
The example in the next section takes into account savings comparisons for the first five years, using another tool besides APR.
Using the Loan Estimate to compare mortgage offers
When you apply for a mortgage, the lender is required to give you a three-page document called a Loan Estimate. Page 3 of the Loan Estimate has a “Comparisons” section that lists not only the APR but also how much the loan will cost in the first five years: the loan costs, plus 60 months of principal, interest and any mortgage insurance.
In the earlier example, Loan A (4.38%) would cost $62,033 in the first five years, and Loan B (4.21%) would cost $62,290. So Loan A would cost $257 less in the first five years. Even if Loan A has a higher APR, it would be the better deal if you owned the house for just five years.
» MORE: Compare mortgage rates