Applying for a mortgage is confusing for most people, even if they've done it before. One of the most difficult concepts for homeowners to grasp is the difference between mortgage interest rates and annual percentage rates (APRs). Both tell you something about the affordability of the loan, but they are not synonymous. Understanding what each number means is key to selecting the right mortgage for you.
To explain the difference between the two, let's see how they work in practice with two 30-year, fixed-rate mortgages. For the purpose of this example, let's assume that there is no private mortgage insurance (PMI).
Which is the better deal? At first glance, Mortgage 2 might appear to be the better option because it offers a lower interest rate, but this is only part of the equation. Note that in the case of Mortgage 2, the borrower paid two discount points. We'll get into what that means shortly.
Interest rates are the cost of borrowing
Whenever you take out a loan, the lender will charge you interest in order to make the transaction worthwhile for them. You'll pay back the amount you borrowed and then some to cover the interest charges. The greater the interest rate, the more you can expect to pay per month and over the lifetime of the loan.
Using our two examples, Mortgage 1 would have monthly payments of $1,267 and a total principal and interest cost of $456,000 over the 30-year term. Mortgage 2 would have monthly payments of $1,194 and a principal and interest cost of $430,000.
Mortgage 2 is still looking like the best option, but interest rates don't take into account the entire cost of the mortgage. There are still discount points, closing costs, and other fees to consider. That's where APR comes in.
APR is a broader measure of a loan's cost
APR is also expressed as a percentage, but it's not a factor in how much you end up paying. Rather, it's an all-inclusive measure that reflects the total cost of a mortgage. Lenders are legally required to disclose APRs when they give you your loan estimate. But that will do you little good if you don't know how to interpret it.
APRs take into account your interest rate, any discount points you pay (usually 1% of the home's value up front in exchange for a 0.25% lower interest rate), and any other fees and costs associated with the loan. This gives you a better sense of the overall cost of loan. A low interest rate may seem appealing, but if you're focused on this alone, you may miss the high up-front costs that make the mortgage less affordable than you thought.
Returning to our examples, Mortgage 1 has an APR of 4.60%, while Mortgage 2 has an APR of 4.33% because, even though the up-front costs are higher, the discount points shave quite a bit off the long-term costs. Based on this information and the interest rate comparison, we can say that Mortgage 2 is the better choice if you plan to stay in the home for the full 30 years. But what if you weren't?
How to use interest rates and APRs to find the best deal
Mortgage 2 may have a lower interest rate, but it also has higher up-front costs. If you hold on to the home for 30 years, the amount you save in interest will be well worth it. But if you turn around and sell the home a couple of years later, you may not have saved enough in interest charges to make up for the high up-front costs you paid. So it's important to think about how long you plan on remaining in the home as well as the interest rates and APRs.
If a low monthly payment is your primary concern, you may want to go with the mortgage that offers the lowest interest rate, regardless of the APR. But for most people, it's best to consider the two numbers in conjunction. When comparing two loans, you should always compare interest rate to interest rate and APR to APR to ensure that you really understand which mortgage offers you the best deal.
If you're getting an adjustable-rate mortgage, it's especially important to look at both numbers, because these APRs usually don't reflect the maximum interest rate. If you don't know what this is, you could find yourself paying a lot more than you expected down the road. You may also find that APRs are not very useful when comparing fixed-rate mortgages with adjustable-rate mortgages.
The distinction between interest rates and APRs is subtle, but it's important to understand when evaluating mortgage options. Take your time comparing them and remember that a mortgage costs more than just the principal and interest charges.
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