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APR vs. interest rate: What you need to know when mortgage shopping
As you go through the home-buying process for the first time, you're bound to encounter different interest rates when looking for loans online or working with mortgage lenders.
We'll discuss what APR means and the difference between APR and interest rate so you can feel confident in the home loan you choose to finance the biggest purchase of your life.
What does APR mean?
APR is an acronym for "annual percentage rate," which reflects the total borrowing costs of your mortgage. Essentially, it’s what you pay on top of the principal balance you borrow.
Your mortgage interest rate is one component that gets factored into your mortgage APR, but since your APR is the full borrowing cost of your home loan on an annualized basis, it includes other expenses. Therefore, your APR will likely be higher than your interest rate.
How does APR work?
Points and fees
The other expenses that could get factored into your mortgage APR, besides your interest rate, include mortgage points, underwriting or origination fees, or select closing costs.
The mortgage points (if applicable), fees, and closing cost elements of your APR impact the amount of money you’ll need when closing on a house. You’ll pay for those expenses in cash to finalize your home loan.
The interest rate
The interest rate aspect of your mortgage APR influences your ongoing monthly payment amount. The higher your interest rate, the higher your housing bill (and overall home loan cost).
You may choose to pay mortgage points to lower your interest rate.
Yahoo Finance tip: The APR calculation processes can vary from lender to lender, so it’s wise to ask your financial institution what costs are reflected in the figures they provide. If you’re looking to do a little research on your own, a good APR calculator can provide you with some estimates.
How to use APR when mortgage shopping
"I think mortgage APR is generally the best way to compare rates because APR includes the origination fees and closing costs," said Ted Erhart, certified financial planner and founder of Norris Lake Retirement Planning, via email interview.
"In other words," said Erhart, "it’s an all-in 'price' for the loan. If you shop for mortgages online, you’ll often see advertisements for what appear to be low rates. But if you look closely, the rate being offered comes with two, three, or even more origination points. Hence, the face rate is misleading because it doesn’t include thousands of dollars of origination and closing costs."
You can find the mortgage APR on page three of the lender-provided Loan Estimate form. Your mortgage lender must give you a copy of this document within three days of receiving your mortgage application.
Yahoo Finance tip: Make sure you compare apples to apples when reviewing your mortgage options. Request that lenders provide Loan Estimates with no mortgage points included.
How can I get a lower APR?
Since the interest rate is one of the main factors that influences your mortgage APR, here are some strategies that may reduce your cost to borrow:
Improving your credit score and reducing debt.
Always compare mortgage offers from several lenders. You may find a lender that charges fewer (or less expensive) fees than another.
The length and type of your mortgage can impact the APR you pay, too.
Dig deeper: 5 ways to get the lowest mortgage rates
When a higher mortgage APR is worth it
While it may seem counterintuitive, there are times when a higher mortgage APR may work in your favor.
"For instance, if the borrower plans to stay in the home for a short period, they might opt for a loan with higher fees (and thus a higher APR) in exchange for a lower interest rate. This strategy can be cost-effective if the lower interest payments outweigh the upfront fees over the time the borrower holds the loan," said Bryan Jordan, certified financial planner and managing partner of Censifi, via email.
Erhart said, "A higher APR could make sense for someone who is more concerned about monthly cash flow as opposed to the interest expense. For example, 15-year terms generally have lower rates and APRs than 30-year mortgages. But many home buyers are willing to pay a higher rate for a lower monthly payment."
Learn more: 15-year vs. 30-year mortgages