|Understanding mortgage APR
When you apply for a mortgage, the lender is required
to tell you the interest rate and the annual percentage rate, or
But what exactly is the APR?
The APR is designed to help you shop for loans by
making them more comparable.
"It's the one common denominator by which
you can compare loans side by side, comparing apples to apples to
apples," says David Newton, an economics professor at Westmont
College in Santa Barbara, Calif.
How to rate a mortgage
As Newton explains it, APR measures the net effective cost
of borrowing -- "the actual present value of those funds over
the length of the contract." In other words, APR answers the
question: "Is it worth it to pay more upfront to get a lower
The federal government requires lenders to quote
APR because loans frequently are offered on different terms. To
extend the inevitable fruit analogy, differing loan terms from different
lenders can make it hard to figure out which offer is a sour persimmon
and which is a real peach. APR helps you identify the peaches.
For example, you might get the
following two quotes for $150,000 mortgages, each for a 30-year
- Lender A offers 6.5 percent with the borrower paying
no discount points and $5,000 in fees;
- Lender B offers 6.25 percent with the borrower
paying 1 discount point ($1,500) and $5,500 in fees, for a total
of $7,000 in points and fees.
Lender B offers a lower interest
rate (or "nominal rate"), but for $2,000 more in points
Which is a better deal? APR gives you a general idea.
Lender A's offer has an APR of 6.83 percent, while
Lender B's offer has an APR of 6.71 percent. Since Lender B's APR
is lower, that loan is a better deal in the long run.
But that's in the long run.
Consider the term
In the short run, Lender A's offer might be better. A look at
the examples above tells why.
Lender B's offer carries a lower APR, but you, the
borrower, have to come up with $2,000 more in cash. What if you
don't have the money, or you have it, but need it to buy appliances?
In those cases, you might prefer the first loan, despite its higher
percentage rate and APR.
Or what if you think you might move within a few
years? Loan A costs $948.10 a month in principal and interest --
$24.52 a month more than Loan B. So with Loan B, you pay $2,000
up front to save a little less than $25 a month. At that rate, it
takes 82 months -- more than 6.5 years -- to recoup the $2,000.
If you sell the house in less than 82 months, Loan A costs less.
On the other hand, if you plan to remain in the house
for the life of the loan, follow Newton's advice: "Don't even
look at the nominal rate," he says. "What you really want
to know is what the net effective cost of funds is, and that's APR."
APR takes into account some costs of getting the
loan, including points, most loan fees and mortgage insurance. It
does not take into account certain charges, including nonrefundable
application fees, late payment charges, title insurance premiums,
and fees for title examination, property appraisals and document
The federal Truth in Lending Act requires the lender
to disclose both the nominal rate and the APR. The nominal rate
can't be stated more conspicuously than the APR.
The APR doesn't have to be perfectly accurate.
The lender can round up or down to the nearest one-eighth of a percentage