Interest
rate versus APR
When you’re shopping for a mortgage, comparing offers can
be difficult. The interest rate lenders use to determine your
monthly payment (also called the note rate) is only one part of
the overall cost of a mortgage. That’s why it’s misleading
to compare loans by looking only at this number. A better means
of comparison is the annual percentage rate, or APR.
The APR formula
The APR formula combines a loan’s interest costs with other
fees charged by a lender over the life of the loan, and
expresses them as a yearly percentage. The APR is therefore a
better reflection of the true cost of borrowing than interest
rates alone and is a good benchmark for comparing loan offers.
The Truth in Lending Act
The Truth in Lending Act requires lenders to prominently post
the APR on any loan advertisement. It’s usually located right
next to the note rate. The idea is to prevent lenders from
posting low note rates to lure borrowers, while at the same time
hiding fees.
How it works
Here’s an example of how a comparison of APRs works in the
case of two loan offers for a 30-year, fixed-rate loan of
$150,000:
Offer A: Quotes an interest rate of 6.5 percent,
plus one discount point and an origination fee of 2 percent.
Offer B: Quotes an interest rate of 6.4 percent, but
charges two discount points, the same origination fee, and
higher closing costs.
While the second loan may carry a lower interest rate and a
lower monthly payment, a comparison of the APRs indicates that
it is actually slightly more expensive overall because of the
higher upfront fees:
| |
Offer A |
Offer B |
| Interest rate |
6.5% |
6.4% |
| Monthly payment |
$948.10 |
$938.26 |
| Discount points |
1 point (1% of $150,000) = $1,500 |
2 points (2% of $150,000) = $3,000 |
| 2% origination fee |
$3,000 |
$3,000 |
| Other closing fees |
$800 |
$1,150 |
| APR |
6.837% |
6.851% |
Other costs
While comparing APRs is far more useful than simply comparing
the note rate when considering different mortgage offers, it
does have some limitations:
- Some upfront costs are not included in the formula -- such
as the home
appraisal, credit reporting fee and title fee --
and these may vary from lender to lender. Don’t forget to
ask for a good faith estimate of closing costs, and ask
which ones are excluded from the APR.
- The APR is much more useful for fixed-rate
mortgages than for adjustable-rate
loans. Because no one can predict how interest rates
will change over the years, the APR for adjustable-rate
mortgages is based on forecasts, which may turn out to be
inaccurate.
- The APR assumes you will keep the loan for its full term,
which may be up to 30 years, but few homeowners ever keep a
mortgage this long. If you plan to refinance
within five to seven years, a loan with higher upfront fees
can end up being more expensive than its APR suggests.
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