When it comes to mortgage loans, often people become confused by the numbers that are provided on quotes. Two numbers that are important to pay attention to when obtaining a mortgage are the advertised interest rate and the APR (annual percentage rate). While these terms may sound the same, the difference between APR and interest rate needs to be fully understood to find a mortgage that will work best and cost the least.
What is a Mortgage Interest Rate?
The interest rate for a mortgage refers to the yearly cost of a loan that the borrower will pay. This number will be expressed as a percentage and does not include any fees that are charged on the loan. An interest rate for a mortgage can be either variable or fixed and will always be expressed as a percentage. For example, if a person considers a mortgage for $200,000 and the interest rate for the loan is 6%, the annual expense for interest would be $12,000 or $1000 a month.
Fixed Interest Rates versus Adjustable Interest Rates
Fixed rate interest on a mortgage refers to an interest rate that will stay the same over the course of the loan. For example, a fixed rate of 6% will remain at 6% the entire term, typically 15 or 30 years. The interest rate on an adjustable rate mortgage will change during the course of the loan. Often an adjustable rate mortgage will offer a lower interest rate to begin with and then increase over time based on different factors and terms as set by the loan.
What is APR?
APR is expressed as a percentage and should be greater or equal to the interest rate, unless the lender is offering a rebate for a portion of interest that is paid on the loan. Taking the example from above, if purchasing the home also requires mortgage insurance, loan origination fees, and closing costs that amount to $5,000, these fees are added to the original $200,000 loan to determine the APR. The interest rate of 6% is used to calculate a yearly payment of $12,300. The annual payment of $12,300 is divided by the original loan amount of $200,000 to get an APR of 6.15%.
Why is APR Used?
The main purpose of APR is to provide borrowers with a comprehensive measure of how much a loan will cost. This number can then be used in order to compare different types of mortgages that are being offered. In addition, it provides a tool to use when comparing loans being offered by different financial institutions. APR is mandated under the Truth in Lending Act, and borrowers will encounter this term as soon as they begin looking for mortgage interest rate quotes because the law requires any interest rate quotes to also show the 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, 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.
Choosing a Mortgage – Short Term vs. Long Term
As mentioned, there are several types of mortgages from which to choose. Most mortgages are offered in 15 or 30 year terms and a fixed or adjustable interest rate can be chosen. This sort of mortgage with a fixed rate is good choice for those who like the idea of a fixed monthly payment and plan on living in the home for more than 7 years. Adjustable rate mortgages will have payments that change over time and typically offer a lower interest rate to begin. These are a good choice for those who are not planning to stay in a home for long or those who are planning to refinance soon.
Overall, it is important to consider both the interest rate of the mortgage and the APR. By understanding the total cost of a loan, buyers are much more likely to choose an option that they can afford without problems down the line. There is more risk with an adjustable rate, so make sure to discuss this carefully with your lender.
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