December 27, 2018

Mortgage Rate vs APR

Read more about Mortgage

Do you like paying more for your mortgage payment than necessary? We didn't think so. But worrying about your mortgage payment or interest rate alone could have you paying thousands of dollars more than necessary.

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Instead, you need to look at the big picture - the APR alongside the interest rate.

Many borrowers make the mistake of focusing on the interest rate alone. They ignore the other factors. They just want the lowest interest rate and/or monthly payment possible. While it may make sense, other factors play a role too. Because that loan will cost you money, the APR may give you a better idea of the true cost of the loan. But it's not the sole indicator.

Look at it this way. The interest rate is the first quote you'll likely receive from a lender. This tells you how much it will cost you to borrow the money from the bank. Let's say a bank quotes you a 4.5% interest rate on a $200,000 mortgage. This means it would cost you 4.5% per month to borrow the money.

But you pay more than just interest to borrow that money. You may pay origination fees, discount points, and other lender fees. The APR includes these fees in its figure. This gives you an idea of the total cost of the mortgage.

When you take on a mortgage, you want to look at the big picture rather than just what it costs you today. Chances are, if you could save a few thousand dollars over the course of your loan's term, you'd be in, right?

Keep reading to learn how to differentiate between the mortgage rate and APR.

What are today's Mortgage Rates?
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Making Sense of the Mortgage Interest Rate

In simple terms, the mortgage interest rate has a direct impact on your mortgage payment. The higher the interest rate, the more your mortgage payment will cost. The opposite is also true - the lower your interest rate, the lower your mortgage payment.

When you look at a mortgage payment, you'll see that it's made up of the principal and interest. The principal is the amount you borrowed minus payments you've made towards it. The interest is the fee the bank charges to let you borrow the money. When you pay your loan down, you pay the principal, not the interest.

You'll likely see two options when talking to a lender about mortgage interest rates:

  • Fixed rate: This rate remains constant for the entire term. For example, if you have a 4.5% fixed interest rate, you'll pay 4.5% until you pay the loan in full.

  • Variable rate: This rate may change based on its chosen index, such as LIBOR or the T-bill plus a predetermined margin as set by the lender. If the interest rate changes, your monthly payment changes too. Typically, though, adjustable rate loans have caps or a limit to how much they can change at one time.

You pay interest on your loan until you pay the principal balance in full.

Why is the APR higher than the Interest Rate?
The APR is more than the interest rate. While it's a part of it, the APR includes things like points and other lender fees expressed as a percentage rate.

What Fees Are Included in the APR?

The APR is more than the interest rate. It's the interest rate plus the fees the lender charges for the loan. The APR usually includes only lender fees, so it's not an all-inclusive figure, as you'll likely pay third-party fees such as appraisal or title fees.

Your monthly payment has nothing to do with the APR. Instead, the APR helps you understand the total cost of the loan plus the third-party fees. It's a good idea to look at the total closing costs on their own too. This includes lender and third-party fees. This will give you an idea of how much you either pay out of pocket or will add to your loan to get the loan closed.

What Should Be More Important - The Interest Rate or APR?

Every borrower will have a different answer to this question. Some borrowers need the absolute lowest mortgage payment they can get. These borrowers benefit from looking at the interest rate rather than the APR. The lower the interest rate, the lower the payment will be, if everything else remains the same.

Other borrowers care more about the cost of the loan over its lifetime. They see homeownership as an investment and want to maximize their return. These borrowers may benefit from looking at the APR. But some consideration may also want to be given to the interest rate. There's no reason to pay more interest on a loan than is necessary. It's the fine balance between the two that you need to find.

What you focus on depends on the following factors:

  • Your time horizon: How long do you plan to stay in the home? Is this your "forever" home or do you plan to move in the next few years?

  • If it's a long-term purchase, paying more upfront and less interest may make sense. You'd focus on the loans with higher APRs, as they generally have more costs but lower interest rates.

  • If it's a shorter-term purchase, paying fewer upfront fees may make more sense. You'll likely have a slightly higher interest rate, but if it's only temporary, it may make more sense than paying high upfront costs that you won't benefit from.

  • Your break-even point: If you want to see if paying more upfront costs makes sense even with a shorter timeline, you need to know your break-even point. Total up the closing costs and divide it by the monthly savings.

Calculating Break-Even Point:

You have the choice between two loans: A 4.5% rate with $3,000 in closing costs or a 4.0% rate with $4,500 in closing costs. Both loans are for a 30-year term on a $200,000 loan.

  • The 4.5% loan will give you a payment of $1,013.
  • The 4.0% loan will give you a payment of $955.

Your break-even point on the 4.0% rate would be:

$1500/58 = 26 months

It would take 26 months to pay off the higher closing costs of $4,500 with a savings of $58/month. If you plan to move shortly before or after 26 months, then consider the higher interest rate option to save money on closing costs.

How to Compare the Interest Rate and APR

When you do compare interest rates and APRs, make sure you don't compare them against one another. In other words, compare interest rates to interest rates and APRs to APRs only.

Before you compare APRS, though, you have to do a little digging. Lenders are supposed to include the lender fees in the APR, but some lenders exclude some fees. If you can't tell from your Loan Estimate which charges are included and which aren't included, ask your lender point-blank. This way, you can compare apples to apples when comparing APRs.

If you can't get a straight answer, you can tally up the closing costs yourself and use that figure along with the interest rate. You can tell which loan costs you the most and then prioritize the loans by interest rate, choosing the factor that is most important to you from there.

What Is a Good APR for a Mortgage?

While there's no number that is perfect for every borrower, a general rule of thumb is to compare the interest rate to the APR on the same loan. Are they within 0.25% of one another? If not, and the APR is much higher than the interest rate, look deeper. Find out what the lender is charging and why. Many times it's due to the points (discount or origination) that the lender charges. Other times, there are miscellaneous lender fees that drive it up. It's important for you to know what it is so that you can either negotiate lower costs or look elsewhere for a mortgage.

Don't Fall for the Lower APR!
It's easy to fall for the lowest APR, thinking you are getting the best deal, if the other factors remain equal. But the APR can be deceiving. The lender that charges points will have a higher APR by default. Another lender could charge the same amount of fees, but not call them points.

They can itemize the fees, therefore leaving them out of the APR calculation. This makes it look like the latter loan is the better choice, when in fact, the APRs would be the same if more fees were included in the calculation.

Bottom Line

It's important to do your research. Ask the lender questions. Know the loan inside and out before you make a choice.

Don't make the mistake of falling for either the lowest interest rate or the lowest APR. You should know exactly what the lender includes in the APR and what they exclude. You should also understand your timeline and break-even point to help you make the best financial decision for your situation.

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