Homebuyers shopping for a mortgage usually look for the lowest interest rate. But another number — the annual percentage rate, or APR — is just as important when trying to determine how much house you…
Homebuyers shopping for a mortgage usually look for the lowest interest rate. But another number — the annual percentage rate, or APR — is just as important when trying to determine how much house you can afford.
The difference between the interest rate and APR is simple, says Bryan Sherman, a consumer lending executive with Bank of America.
The interest rate represents the yearly cost you pay to borrow the money in your mortgage loan. It does not include other fees or charges.
“The interest rate is what’s going to drive that monthly payment,” Sherman says.
By contrast, the annual percentage rate is the annual cost of the loan inclusive of fees, Sherman says.
Fees included in the APR can add significantly to the costs a buyer will pay. Examples of such fees are:
Knowing both a loan’s interest rate and its APR can be helpful when shopping for a mortgage. But because the APR is a broader measure of costs, it can be an especially useful measuring tool, Sherman says.
“Many times to a consumer, the annual percentage rate is a better assessment of the transaction and the deal they are getting,” he says.
How to Compare Rates Among Lenders
One quick way to compare the interest rate and APR among lenders is to look at the loan estimate from each of them, says Joe Zeibert, senior director of products, pricing and credit for Ally Home.
“The loan estimate is standard across all lenders,” he says. “It’s a government document that will look the same.”
Page 1 of the loan estimate displays the interest rate under the loan terms section. Page 3 of the loan estimate lists the APR under the comparisons section.
Sherman says looking at the APR is often the best way to get a sense of which lender is offering the best deal.
“If [borrowers] wanted to compare apples to apples, they would compare the APR that one lender quoted them versus the APR that another lender quoted them,” Sherman says.
In many cases, an interest rate that appears appealing may become less so once the borrower looks at the associated APR.
To illustrate, Sherman cites a scenario where one lender charges an interest rate of 5 percent with no points, while a second lender charges an interest rate of 4.875 percent with one discount point, which typically costs 1 percent of the loan.
In such a situation, it is possible for the first loan to be the better deal, even though the interest rate is higher. “Even though my rate is higher, my APR might be lower,” Sherman says. “So, interest rate isn’t always everything.”
Does APR Offer the Full Picture?
Zeibert notes that simply looking at the APR does not always reveal the full picture, especially if interest rates differ among lenders you are comparing.
The APR might not capture some other costs. “The loan estimate is also going to have a lot of other fees that might not necessarily be in the APR,” he says. Such expenses might include fees for title insurance examinations or property surveys.
“If you are close and you’re between two lenders, make sure you look at those loan estimates and go all the way down,” Zeibert says. “The line items will match up perfectly, and you’ll be able to see where they are charging you more.”
The Consumer Financial Protection Bureau warns of other shortcomings in using the APR as a measuring tool, including:
— The APR on adjustable-rate loans does not reflect the possible maximum interest rate.
— It can be misleading to compare the APRs on fixed-rate loans with those of adjustable-rate loans, or of one adjustable-rate loan with another.
So, if you plan to shop for an adjustable-rate mortgage, understand that you can’t reliably predict how interest rates might rise or fall in coming years. Although the APR can be calculated for the initial fixed period of the loan, such as the first five years on a 5/1 ARM, you don’t know how rates will behave after that initial period. The APR accounts for future rate adjustments, but it does so based on today’s market conditions.
Is Interest Rate or APR More Important to You?
As a general rule, people who want a lower monthly payment should focus on a lower interest rate. On the other hand, borrowers who want a lower overall loan cost should focus on the APR.
For example, suppose you plan to live in your home for 30 years. In that case, a low interest rate might be the most important factor. “I want the rate to be low because I’m going to be in this house for a long time,” Zeibert says. To get a lower interest rate, you might be willing to pay points that will lower the interest rate but increase the APR.
By contrast, if you only plan to stay in a home for a year or two and then move, it might make more sense to accept a higher rate rather than to pay points to lower it. “You don’t want to pay an extra $5,000 to make your rate lower if you’re going to move in a year,” he says.
In addition, finding the right loan includes not just zeroing in on rates, Zeibert says.
Instead, it is important to also weigh other factors. “You want to make sure you have a solid financial deal with an institution that you trust — that you do business with and that you know,” Zeibert says.
Because finding the right mortgage can be so confounding, it often makes sense to seek help in making the decision.
Zeibert says a lot of homebuyers get into trouble because they don’t talk to an expert — such as a loan officer, mortgage broker or real estate agent — who can guide them through their options.
“There’s not necessarily a right product and a wrong product in the market,” he says. “But there is going to be a right product and a wrong product for you.”
To get the best guidance, give your expert some basic pieces of information, Zeibert says. They include:
— Your homeownership goals
— Your job status and income level
— Your level of debt
— How much you are willing to spend on a house
— How much money you intend to put down and where that money is coming from
“Have a picture of your own personal balance sheet and where you stand,” Zeibert says.
Also keep in mind that an expert making a recommendation may be getting a fee from your mortgage. Before meeting with an expert, continue to educate yourself as much as possible about loan terminology and your own financial situation. Then, remain open to the suggestions the expert gives you.