Mortgages Part 6B: Understanding Mortgage Terms - APR

When you apply for a mortgage, the lender is required to tell you the interest rate and a number called the APR. 

What is APR?

APR stands for annual percentage rate. The interest rate is the one used to calculate your mortgage payment. The APR is designed to help you shop for loans by making them more comparable.

For example, you want to compare two loans. You want to borrow $100,000, and both loans are offered at 5% for 30 years. For both loans, your monthly payment is $536.82. However, loan A costs $1000 in fees, while loan B costs $4000 in fees. In this case, loan B will have a higher APR than loan A.

Why? That is because the mortgage fees are added into the loan amount when the APR is calculated. It is pretty obvious that loan A is a better deal in the example above. But what if loan A costs $1000 in fees at 5% interests, while loan B costs $4000 in fees at 4.5%? This is when the APR comes in handy. The lender is required to tell you that the APR of loan A is 5.09%, while the APR for loan B is 4.85%.

So is it that simple? Should you always choose a mortgage with a lower APR?

How to compare mortgages

Based on the APR above, loan B costs less than loan A over the life of the loan. That is only if you keep the house and mortgage for the entire 30 years. In the short run, Loan A might be a better choice. Loan B carries a lower APR, but you have to come up with $3,000 more in cash.

What if you don't have the money, or you would rather save it for appliances and furniture? In those cases, you might prefer the first loan, despite its higher percentage rate and APR.

Or what if you think you might move within a few years? Just like discount points from the previous article, it may not be worth it to take a loan that requires more money upfront if you plan to move in a few years. In the above example, Loan A costs $536.82 and loan B costs $506.69 per month. You will save $30 a month with loan B, or $360 per year. For you to break even, you will need to stay with the house for over 8 years.

What fees are added to calculate the APR?

The APR takes into account most mortgage fees, including points, most loan fees, and mortgage insurance. It does not take into account any nonrefundable application fees, late payment charges, appraisal fee, title insurance premium, or document preparation fee.

Also, if you are getting an adjustable rate mortgage, nobody knows what the actual APR will be once the loan readjusts. The APR is calculated assuming the loan is being adjusted today. It is highly unlikely that rates on the dates of adjustments will be exactly what they are today, so just remember that when you compare APRs of ARMs.

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