Mortgage Rate vs APR -- Which Is Better?

Mortgage rate vs APR -- which tells you more about real estate loans? Every advertisement for mortgages that includes an interest rate must by law also display the annual percentage rate, or APR. That number is supposed to make shopping for a home loan easier. But does it?

Which Is Better? Neither

The answer may be surprising because both figures are fairly inadequate; neither tells quite the whole story regarding mortgage costs because of the way real estate financing is marketed and sold.

For instance, imagine that you wanted to borrow $100,000 at four percent. This seems fairly straightforward, but what about related charges and fees? Maybe two lenders both offer "four percent financing" but the fees differ, so which lender has the better offer?

Mortgage Rate vs APR

In general terms, we can think of the mortgage rate for a home loan as just a variable in a formula. That rate, also called the stated rate or advertised rate, is the number used to calculate your mortgage payments. Every 30-year fixed $100,000 mortgage with a 4.00 percent mortgage rate has the same $477.42 principal and interest payment, no matter what their APRs are. It's just math.

The APR -- the annual percentage rate -- is different. According to the Federal Trade Commission, the "APR takes into account not only the interest rate but also points, broker fees, and certain other credit charges that you may be required to pay, expressed as a yearly rate." If you look at five 30-year fixed-rate $100,000 mortgages with different costs, their mortgage payments are identical, but their APRs are different. The table below shows how this works:

how costs affect apr

The stated rate is four percent in every case. However, the borrower might not receive $100,000 at closing. What if he or she borrows $100,000, but pays the lender $1,500 in loan fees? The result is that the $477.42 monthly payment actually covers $98,500, not $100,000. If you borrow $98,500 for 30 years and pay $477.42 per month, your "real" interest rate, or APR, is 4.126 percent.

Using APR to Compare Mortgages

APR is supposed to help consumers compare loans when the rates and costs are different. It's pretty easy to tell that a four percent loan with no fees is better than one with $5,000 in fees. But what if one loan has a rate of 3.875 percent and costs $2,000, while another loan at 4.125 percent costs nothing? The table below shows how APR can help you choose between loans with different rates and charges. The loan with the lowest APR has the lowest cost over the life of the loan. In this case, it's the 3.75 percent loan with $3,000 in costs.

how apr varies with rates and fees

How APR Can Mislead You

Many consumers (and some finance writers) interpret this to mean you should always choose the loan with the lowest APR. But there's a catch: how many people hold a mortgage for 30 years? Not many, because homes are routinely sold or refinanced in far less time. According to Freddie Mac, the typical mortgage is paid off after just seven years.

Let's take another look at the loan: If a $98,500 mortgage is paid off after seven years, it means the $1,500 paid upfront did not reduce the mortgage rate and payment for 30 years; those costs must now be allocated over seven years.
The table below shows how this relationship works for a four percent $100,000 loan with $1,500 in fees:

how apr works over time

What ARE Those "Certain" Charges?

But that's not all. What are "certain" other credit charges? Are there any charges which are not included? The law is vague, and lenders don't always include the same costs when disclosing the APR. Slight variances in APR could be meaningless when comparing home loans.

To simplify mortgage rate vs APR comparisons, you could always choose a "no cost" refinance. In this situation, you trade a higher rate for no loan costs at closing. The disclosed APR might be higher, but your "real" rate, the one with loan costs spread out over fewer years, may be lower. In addition, you're getting the benefit of a closing with few if any out-of-pocket loan expenses. In a cash-short world, this may be an attractive deal if it results in a materially lower monthly loan cost.

While it's useful to look at mortgage rate vs APR questions there's another measure you might want to consider: Ask mortgage lenders to quote mortgage rates without points. This is called "par" pricing and lets you compare loan prices with zero points -- then look at the APRs.

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