When you’re shopping for a home loan, you’ll see lenders advertise their best mortgage interest rate vs. APR, or annual percentage rate. They’re required to show you both rates, because APR gives you a sense of the lender’s fees in addition to the interest rate. As a borrower, you need to know if a lender is making up for a low advertised interest rate with high fees, and that’s what the APR can tell you. If the APR is close to the interest rate, you’ll know that the lender’s fees are low.
We’ll explain how lenders use APR vs. interest rate and how you can use your new understanding of these terms to save money on your home loan. Even if you already think you understand how APR works from your experience with credit cards and auto loans, there’s a lot you may not know about how APR works for home loans.
What Is an Interest Rate?
An interest rate is the cost to borrow money. When you borrow money to buy a home or a car, you pay interest. When you lend money, you earn interest. If you have a savings account or certificate of deposit, you’re lending money to a bank and they’re paying you a small return so you’ll have an incentive to put your money there.
Interest is usually expressed as an annual rate. Freddie Mac, which publishes a weekly Primary Mortgage Market survey, found in late August 2020 the U.S. average weekly mortgage rate was 2.91% on a 30-year fixed-rate mortgage.
What Is APR?
APR, or annual percentage rate, is a calculation that includes both a loan’s interest rate and a loan’s finance charges, expressed as an annual cost over the life of the loan. In other words, it’s the total cost of credit. APR accounts for interest, fees and time.
Going back to Freddie Mac’s Primary Mortgage Market survey, there’s an important piece of additional information you need to know: The average interest rate of 2.91% comes with an average of 0.8 fees and points, or $800 for every $100,000 borrowed. So the national average APR on a 30-year fixed-rate home loan was 2.99% at the end of August.
APR vs. Interest Rate: Why These Numbers Matter in a Mortgage
Since APR includes both the interest rate and certain fees associated with a home loan, APR can help you understand the total cost of a mortgage if you keep it for the entire term. The APR will usually be higher than the interest rate, but there are exceptions.
One is a no-closing-cost refinance: In this case, the interest rate and APR will be the same.
Another is an adjustable-rate mortgage (ARM). The APR for an ARM will sometimes be lower than the interest rate. This can happen in a declining interest rate environment when lenders can assume in their advertising that your interest rate will be lower when it resets than when you take out the loan.
However, the APR on an adjustable-rate mortgage is only an estimate, because no one can predict what will happen to interest rates over your loan term. Your APR on an ARM will only be knowable after you’ve paid off the loan.
Using APR to Compare Mortgage Offers
Comparing APRs is not the best way to evaluate mortgage offers. Instead, it’s more useful as a regulatory tool to protect consumers against misleading advertising.
Federal Regulation Z, the Truth in Lending Act, requires lenders to disclose a loan’s APR when they advertise its interest rate. As a result, when you’re checking out lenders’ websites to see who might give you the best interest rate, you’ll be able to tell from looking at the APR if the lender with the great interest rate is going to charge you a bunch of fees, making the deal not so great after all.
Page 3 of the loan estimate that lenders are required to give you when you apply for a mortgage shows the loan’s APR. By comparing loan estimates (mortgage offers), you can easily compare APRs.
Still, most borrowers shouldn’t use APRs as a comparison tool because most of us don’t get a single mortgage and keep it until it’s paid off. Instead, we sell or refinance our homes every few years and end up with a different mortgage.
If you’re looking at two loans and one has a lower interest rate but higher fees, and the other has a higher interest rate but lower fees, you might discover that the loan with the higher APR is actually less expensive if you’re keeping the loan for a shorter term, as the table below illustrates.
You’ll need to use a calculator and do the math on the actual offers lenders are giving you to make this comparison for your own situation and see which offer benefits you the most, given how long you expect to keep your loan. Keep in mind that economic and life circumstances can change, and you might not end up moving or refinancing in a few years even if that’s your plan now.
Which Loan Is Cheaper? Interest Rate vs. APR
| | | ||
|---|---|---|---|
| Time into loan | Total costs [(interest+principal)*months]+ fees | Total costs [(interest+principal)*months]+ fees | Difference |
| 3 years | ($843*36) + $10,000 = $40,348 | ($886*36) + $4,000 = $35,896 | $4,452: Loan 2 is cheaper |
| 5 years | ($843*60) + $10,000 = $60,580 | ($886*60) + $4,000 = $57,160 | $3,420: Loan 2 is cheaper |
| 7 years | ($843*84) + $10,000 = $80,812 | ($886*84) + $4,000 = $78,424 | $2,388: Loan 2 is cheaper |
| 10 years | ($843*120) + $10,000 = $111,160 | ($886*120) + $4,000 = $110,320 | $840: Loan 2 is cheaper |
| 11 years, 8 months | ($843*140) + $10,000 = $128,020 | ($886*140) + $4,000 = $128,040 | $20: Loan 1 is cheaper |
| 15 years | ($843*180) + $10,000 = $161,740 | ($886*180) + $4,000 = $163,480 | $1,740: Loan 1 is cheaper |
| 30 years | ($843*360) + $10,000 = $313,480 | ($886*360) + $4,000 = $322,960 | $9,480: Loan 1 is cheaper |
Eventually, you might pay off your mortgage and own your home free and clear, ideally before retirement—unless you’re the type who’s happy to carry a low-rate mortgage so you can have extra cash to invest (with the hope of earning a higher return than your mortgage rate).
But each time you get a new loan, you pay closing costs all over again, except in the case of a no-closing-cost refinance. That means all the loan fees you pay should really be averaged out over, say, five years or however long you think you’ll keep the loan, not 15 or 30 years, to give you an accurate APR. You can do this math yourself with an online APR calculator. This same logic can help you determine whether it makes sense to pay mortgage points.
Loan Estimates, APRs and 5-Year Costs
Your loan estimate accounts for the possibility that you won’t keep your loan for its full term by showing how much the loan will cost you in principal, interest, mortgage insurance and loan fees over the first five years. If you don’t think you’ll keep your loan forever, comparing five-year costs can be more useful than comparing APRs. The five-year cost also appears on Page 3 of the loan estimate, right above APR.
If you do use APR to compare mortgage offers, make sure you’re comparing offers for the exact same type of mortgage. Don’t compare the APR on a 15-year fixed-rate mortgage to the APR on a 30-year fixed-rate mortgage, or to the APR on a 5/1 ARM, because the comparison won’t tell you anything.
That said, one situation where comparing APRs on slightly different mortgage types can be useful is when comparing a conventional 30-year loan to an FHA 30-year loan. The APR can give you an idea of how much more expensive the FHA loan may be due to its upfront and monthly mortgage insurance premiums.
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What Fees Are Included in Mortgage APR?
Federal law requires lenders to include these charges in a mortgage APR:
APR may also include prepaid interest, any loan application fee, any underwriting fee and other lender charges.
Federal law says lenders should not include these finance charges in a mortgage APR:
- Title examination and title insurance fees
- Closing agent’s loan document preparation fees
- Escrowed amounts for property taxes and homeowners insurance
- Notary fees
- Home appraisal fees
- Pest inspection fees
- Flood hazard determination fees
- Credit report fees
- Settlement or escrow agent fees
- Attorney fees
- Government-imposed recording fees
- Government-imposed property transfer tax
All of these fees are third-party fees: The money you pay for them does not go to the lender. It goes to the title insurance company, the notary, the home appraiser and so on. That said, lenders often select affiliated service providers that they have a financial incentive to work with. For example, Quicken Loans, the nation’s largest mortgage lender by origination volume (number of loans closed), is affiliated with Amrock, a title insurance, mortgage settlement and home appraisal company.
Borrowers are free to choose which providers to work with for some of these services, which means that the borrower and the third-party providers, not the lender, ultimately control these costs. You might not be able to choose whether to pay them, but you might be able to influence how much you pay for them.
To see which services you can shop for, look at your loan estimate. These services are allowed to vary by lender. Title insurance is one item you can often choose the provider for.
The reality is that lenders won’t always charge the exact same set of fees. They might even differ in what they choose to include in APR. So it’s also important to ask your lender which fees are included in its APR if you want to have any hope of accurately comparing APRs between lenders. And remember that APR is only one factor that affects how much house you can afford.
