Homebuyers often seek the lowest mortgage interest rate, but another number – the annual percentage rate, or APR – is just as important when deciding how much house you can afford.
The difference between the interest rate and the APR is simple, says Bryan Sherman, a consumer lending executive with Bank of America.
The interest rate is the annual cost of borrowing the principal loan amount, expressed as a percentage, and does not include all fees you’ll pay for the loan. “The interest rate is what’s going to drive that monthly payment,” Sherman says.
By contrast, the APR is the annual cost of the loan, including fees. The APR reflects the true cost of borrowing, which is why it is often higher than the interest rate.
Knowing the interest rate and the APR for a loan 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 Can You Compare Mortgage Interest Rates and APRs Among Lenders?
One quick way to compare interest rates and APRs among lenders is to look at the loan estimates from them, says Joe Zeibert, managing director of Global Mortgage Solutions at Nomis Solutions.
“The loan estimate is standard across all lenders,” says Zeibert, who helps top global lenders with mortgage pricing and strategy. “It’s a government document that will look the same.”
You’ll find the interest rate on the first page of the loan estimate; the APR is on the third page. 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,” he says.
In many cases, an interest rate that appears appealing may be less so once the borrower looks at the APR.
Sherman cites the example of one lender that charges 4% interest with no points and another that charges 3.875% interest with one discount point, which typically costs 1% of the loan amount. The first loan could be a better deal, even though the interest rate is higher.
“Even though my rate is higher, my APR might be lower,” Sherman says.
Does APR Offer the Full Picture?
The APR might not capture every cost. Your loan estimate may not include title examinations or property surveys, for example.
“Make sure you look at those loan estimates and go all the way down,” Zeibert says.
The line items will match up perfectly, so you can easily compare and see where a lender might be charging you more.
If you’re shopping for an adjustable-rate mortgage, the APR has shortcomings as a measuring tool.
Do not compare the APR of a fixed-rate loan with the APR of an ARM. The ARM’s APR can fluctuate, and the loan estimate won’t reflect the highest possible interest rate.
You also can’t reliably predict how interest rates might rise or fall during your loan term. But you can calculate the APR for the initial fixed period of a loan, such as the first five years of a 5/1 ARM.
The APR can be misleading as well if financial hardship means you need to defer mortgage payments. A longer loan term lowers your APR if your interest rate stays the same but increases the total amount repaid.
The longer you spread out payments, the less of an effect fees have on the APR.
Is a Lower Interest Rate or Lower APR Better?
The answer to this question depends on what is more important to you: the lowest possible monthly mortgage payment or the lowest possible total loan cost.
Focus on the interest rate if the monthly payment is your priority and the APR if the overall loan cost is your concern.
If you plan to live in your home for 30 years, a low interest rate might be the most important factor. You might be willing to pay points that will lower your interest rate but increase your APR.
“I want the rate to be low because I’m going to be in this house for a long time,” Zeibert says.
Sometimes this doesn’t make sense, though. “You don’t want to pay an extra $5,000 (in points) to make your rate lower if you’re going to move in a year,” he says.