Considering taking on a mortgage can be confusing and overwhelming. There’s an endless amount of information and advice and weeding through it can be a monumental task. When you get a mortgage, you are charged two different rates—the annual percentage rate and the interest rate. Understanding the difference between the two rates is important and will help you make an informed decision when shopping for the right lender and the right loan. What is the difference between APR and mortgage interest rate? How will they actually affect you now, or in the long run? We’ll answer these questions in this article.
The interest rate is the yearly rate a lender charges for permitting the borrower to use money for a specific length of time. It’s the portion of your mortgage loan that you will pay in interest. Consider it as the price the lender charges you in exchange for their services, and in your case, loaning you the amount of money you need for your new home. The rate is calculated by dividing the total amount of interest charged by the loan amount. For example, if a lender charges a client $60 a year on a loan of $1,000, then the interest rate would be (60/1000) x 100% = 6%.
Annual Percentage Rate
The APR is a little more complex and consists of two factors: it includes your actual interest rate and any additional costs. Additional costs might include things like prepaid interest, private mortgage insurance, or closing fees. Your APR represents the total cost of credit on a yearly basis after all charges are taken into consideration. It is typically higher than your actual interest rate because it includes these additional items and assumes you will keep the loan for the full term.
While the APR gives a wider picture of total costs, it’s not as exact. It’s an estimate—usually based on the assumption that you’ll reside in the home for the duration of the mortgage. Different institutions may include or leave out different fees, which makes comparing the APR more difficult. Be sure to ask the lenders which fees and costs they include in their APR.
Should all Borrowers Consider the APR when Choosing a Mortgage?
While the APR provides insight as to how much a borrower will pay for a loan, it is not important for all borrowers to consider. Borrowers who are planning to refinance or sell the home within 7 years do not need to consider the APR. The reason for this is because over shorter periods the APR is biased to favor loans that offer lower interest rates combined with high fees. Essentially, the APR combines the fees with the interest that is paid each month; this means that the APR assumes the loan will run its full term. It is this assumption that creates the bias that a loan with a low interest rate and higher fees creates a lower APR.
It is important to remember that APR is determined for the life of the loan. For example, when shopping for a $200,000 mortgage one offer may come with a 4% interest rate, $1,500 in fees, and an APR of 4.06%. The other loan may offer a 3.75% interest rate, $4,000 in fees, and an APR of 3.91%. While it may seem like the best choice is the loan that offers a 3.5% interest rate, it is important to understand that if the house is sold or the mortgage is refinanced after 7 years, the APR would be 4.22% for the first loan and 4.34% on the second, making the first loan the less expensive option.
Fixed Versus Adjustable Interest and APR
As mentioned earlier, another consideration when determining the APR for a mortgage is whether or not a fixed interest rate or adjustable interest rate is chosen. It is easier to determine the APR for a fixed rate mortgage than it is for an adjustable rate mortgage. The main reason for this is because fixed rate mortgages provide an exact amount of interest charged over the life of the loan. An adjustable rate will change over the course of the loan, which means the exact APR will change as well.
When shopping for a mortgage, especially if it’s your first time, it’s important to understand the terminology surrounding the mortgage process. So—do your research. Find out as much as you can so that you understand the loan process to make an educated and informed decision when it comes time to choose a loan and lender.
Lone Star Financing Can Help
At Lone Star Financing, we are a Texas-based mortgage company that can help you through every step of financing your new home. Fill out the quick contact form or call Lone Star Financing today at 1-800-960-4565 to speak with one of our Texas mortgage specialists and get a free good faith estimate.