You could end up paying thousands of dollars more to finance a home purchase if you don’t understand the difference between the interest rate and the annual percentage rate (APR) of a mortgage. Most homebuyers don’t know that the interest rate and the APR measure two separate costs of a home loan.
Interest rate vs. APR
The interest rate is the cost of borrowing the principal loan amount. It can be variable or fixed, but it’s always expressed as a percentage. An APR is a broader measure of the cost of a mortgage because it includes the interest rate plus other costs such as broker fees, discount points and some closing costs, expressed as a percentage.
Monthly payment vs. overall cost
“The main difference is that the interest rate calculates what your actual monthly payment will be,” says Sean O. McGeehan, a mortgage sales manager in Chicago. “The APR calculates the total cost of the loan. A consumer can use one or both to make apples-to-apples comparisons when shopping for loans.”
For example, a loan with a 4 percent rate will have a lower monthly payment than a loan with a 6 percent rate, assuming both are fixed for the same term. Likewise, the total cost of a loan with a 4 percent APR will be less than one with a 6 percent APR.
Buyer determines which number matters more
Borrowers should be able to use both percentages to determine their total costs. The trick, McGeehan says, is to understand the interplay between the two figures.
“If a consumer is only focused on getting the lowest monthly payment, they should focus on the interest rate,” McGeehan says. “But if the consumer is focused on the total cost of the loan, then they can use the APR as a tool to compare the total cost of two loans.”
This chart compares the interest rate, APR and total costs over time for a $200,000 mortgage in which 1.5 discount points cut the interest rate by a quarter of a percentage point, and another 1.5 discount points cut the interest rate by another quarter of a percentage point.
|Points and fees||$2,800||$5,800||$8,800|
|All costs, 3 years||$39,281||$41,220||$43,174|
|All costs, 10 years||$124,404||$123,866||$123,380|
|All costs, 30 years||$367,613||$354,197||$343,739|
Time horizon matters
If you plan to stay in your home for 30 years or more, it makes sense to take out a loan that has the lowest APR because you’ll end up paying the lowest amount possible for your house. But if you don’t plan to stay in the house that long, it may make sense to pay fewer upfront fees and get a higher rate — and a higher APR — because the total cost will be less over the first few years.
“Because APR spreads the fees over the course of the entire loan, its value is optimized only if a borrower plans to stay in the home throughout the entire mortgage,” says Gloria Shulman, founder of CenTek Capital Group in Beverly Hills, California.
Figure the break-even point
For example, if you chose a 0.25 percent lower rate for an additional 1.5 points because of the lower APR, but you moved in five years, you lost money. Your break-even on the points was seven years.
Unfortunately, those calculations are often confusing to most homeowners, which is why it’s important to choose the right lender.