Interest rate versus APR

Don’t compare loan offers based on interest rate alone. Consider their annual percentage rate (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.


 

Published on August 21, 2006
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