APR vs Interest Rate: What's the "Real" Mortgage Rate?

If you pay much attention to mortgage advertising, you've probably noticed that there are two interest rates on every promotional email, flier, banner or TV spot. There's an interest rate (often accompanied by exclamation points) and then there's an APR. "APR" stands for "annual percentage rate," and it's usually higher than the interest rate. So which of these mortgage rates is the "real" one? The rate or the APR?

APR vs Interest Rate: Here's the Deal

The APR was created to help consumers compare loan offers, because there are two ways lenders make money with mortgages. There's the interest that borrowers pay, and there are the fees. For example, if three lenders all offered "3.75 percent 30-year fixed mortgages," most people would think the loans were the same. However, if Lender A charges $1,000 to originate its loan, while Lender B charges $4,000 and Lender C charges nothing, it's obvious that the loans are not the same. That's what APR is intended to convey.

The Stated or Advertised Mortgage Rate

The stated interest rate is what most people think of when someone says "mortgage rate." It's the number used to calculate your mortgage payment. Lenders A, B and C charge different fees for their mortgages, but their loans all have the same rate – 3.75 percent. Regardless of which loan you choose, your principal and interest payment for a $100,000 mortgage will be $463.12. That 3.75 percent represents the interest that the lender will earn.

The Annual Percentage Rate, or APR

In addition to a loan's interest, however, lenders can also earn income by charging fees for making loans. So Lender A's customers pay $1,000 in addition to their interest, Lender B's customers pay $4,000, and Lender C's customers pay no fees. APR is a calculation designed to incorporate both the interest charged and the loan fees. If the borrower were to pay for mortgage insurance, this too would be included in the APR calculation. Here are the APRs for the three $100,000 loans:

  • Lender A: 3.831%
  • Lender B: 4.073%
  • Lender C: 3.750%

You probably didn't need to calculate the APR to see that Lender C offered the best deal. But what if the three loans looked like this?

  • Lender A: 3.875% for $2,500
  • Lender B: 3.750% for $4,000
  • Lender C: 4.000% for $0

This is where the APR for a loan comes in handy. Here are the APRs.

  • Lender A: 4.079%
  • Lender B: 4.073%
  • Lender C: 4.000%

So Lender C has the highest interest rate but the lowest APR. That's your best deal.

Is the Lowest APR Always the Best Deal?

The lowest APR is not always the best deal. The reason that Lender C's deal is the best is that it is both the loan with the lowest APR and the loan with the lowest upfront costs. But this doesn't happen all the time. Check out these loan options:

  • Lender A: 3.875% for $4,000
  • Lender B: 3.500% for $5,000
  • Lender C: 4.250% for $2,500

Here are the APRs:

  • Lender A: 4.201%
  • Lender B: 3.897%
  • Lender C: 4.408%

Lender B has the lowest APR, but that doesn't mean its loan is the best deal. Lender B's deal is the best if the borrower keeps that loan for its entire 30-year term. In exchange for that $5,000 upfront payment, Lender B offers a loan with a lower rate and payment. Lender B's payment is $449.04, while Lender C's payment is $491.94. The difference is $42.90 per month, and for that savings, Lender B charges an extra $2,500. It will take just over 58 months ($2,500 / $42.90) before the borrower breaks even and begins to save money with Loan B. If the borrower expects to keep the loan for six or years, Loan B is a good deal. But if borrowers are unsure about their timeframes, a loan with fewer upfront fees might be a better deal.

OK, So Which Is the "Real" Rate? APR vs Interest Rate

For mortgage comparison purposes, the APR is your real rate. But for calculating your monthly payment, the stated rate is the figure you'll use.

There are a couple more rules for comparing loan APRs.

APR can only be used to compare the same kind of loans – 30-year fixed to 30-year fixed, 5/1 ARM to 5/1 ARM, and so on.

APRs for adjustable rate mortgages are calculated on the assumption that the loans will be fixed for their introductory periods and then adjust according to today's economic index values ("today" being the date that disclosures are issued). So the APR for a 5/1 LIBOR ARM, which is fixed for five years and then begins adjusting based on the LIBOR index, would be calculated on the assumption that it will remain at its start rate for five years, adjust according to today's LIBOR, and stay that way for the remaining 25 years. This scenario is so unreliable that only under an extreme stretch of the imagination could it be considered a "real" rate.

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