APR vs. Interest Rate? Understand The Lingo
If you’ve done any mortgage shopping, you’ve probably been paying a lot of attention to mortgage rates; in fact, that’s arguably the single factor most would-be borrowers look at when comparing one mortgage to another. But what you may not have noticed is that the interest rate that’s being advertised is not the actual rate a borrower will end up paying. That rate is called the APR, or annual percentage rate. Understanding differences between an APR vs. interest rate is paramount to getting favorable terms on your loan.
The interest rate that’s advertised for the loan is the actual interest rate that’s applied when calculating how much you’ll pay each month. But, since loans come with fees and costs, most of which are paid at closing, the actual cost of a loan can vary significantly from what the interest rate would imply. Here’s why: Consider a 30-year $100,000 loan at 5%. Plug it into a mortgage calculator and you’ll see your monthly payment would be $536.82. OK. But what would happen if that loan has closing costs of $1,000? Once those costs are taken into account, you’re really only getting $99,000 but you’re still paying $536.82 per month based on that 5% interest rate, which means the interest rate you’re really paying – the APR – is really about 5.1%. Not such a big difference, but what if closing costs were $5,000? Now the loan value is really going to be only $95,000 after closing costs are taken into consideration. But based on that 5% interest rate, you’re paying the same $536.82 per month, which translates into a “true” annual percentage rate of about 5.46% – and that is a considerable difference.
The APR is even more important when you compare loans with different advertised rates – for instance, a $100,000 loan at 5% with $1,000 closing costs versus a $100,000 loan at 4% with $4,000 closing costs. At first glance, if you only compare advertised interest rates the 4% loan looks like the obvious choice, right? But have a look: The APR on the 5% loan is about 5.1% while the APR on the 4% loan is just under 5.38%. In this case, the 5% loan is actually the better deal.
Pretty straightforward, right? Well, not always. These calculations assume you’re keeping your loan for the full term. If you decide to pay off your mortgage early – say you move in a few years – those closing costs are spread out over a shorter period of time, which means higher closing costs are even more costly. (Here’s where a mortgage calculator really comes in handy.)
Actually, having the APR posted is good for you, the buyer (it’s also required by law). To truly compare loans and understand which loan is the better deal, the APR is the only way to go. Left to their own devices, banks would far rather just talk about the advertised rate because it’s almost always lower than the APR. In the world of mortgages, the APR is like eating your vegetables: It’s not always fun to do, but it ends up being good for you in the long run.