There are many factors you need to consider as a prospective homebuyer. Your budget, the type of loan, interest rates, and other aspects must be taken into account. But, there’s one key indicator that’s often overlooked.
The annual percentage rate (APR) is considered the most important factor when comparing mortgage loans. Before we explore its role in the mortgage process, let’s explain what it means.
Definition of APR
In simple terms, APR tells you how much it costs to borrow money.
It reflects the interest rate plus any fees related to your mortgage loan as an annual rate. Thus, it provides a broader measure of the cost of taking out a loan than just the interest rate. This is also why your APR will typically be higher than your interest rate.
An annual percentage rate doesn’t take compounding interest into account. This is because it's solely based on simple interest. So, tack on associated fees to the interest rate, and you’ll get your APR.
What fees does the APR include?
Your APR will include origination fees, underwriting fees, and closing fees. Basically, these are the lender’s costs in extending you the loan. Likewise, costs that usually aren’t included are home inspections, property survey fees, and title insurance fees.
The fees which affect the annual percentage rate may be up to your lender’s discretion. For example, mortgage insurance can be included in your APR depending on the lender.
Why is the APR important?
APR is known as the actual cost of financing. It paints a more accurate picture of the total borrowing cost than the interest rate. This is due to the associated fees it includes. As a result, the APR is considered the most important factor when shopping for mortgages.
If you ignore the APR when you take out a loan, you could end up paying more money over the life of the loan. This is why APR matters. It allows you to compare and contrast the real cost of borrowing before you pull the trigger on taking out a mortgage.
What is APR on a mortgage?
We now know the definition of APR in relation to loans. But, what’s its purpose for a mortgage loan?
Ultimately, the APR works on a mortgage loan by acting as an informational tool. By revealing the total borrowing cost, it helps you weigh offers from different lenders. Thus, the annual percentage rate is a key factor you should look at when comparing loans.
Is it better to have a high or low APR?
It’s tough to say what the “perfect” APR for a mortgage is because it varies depending on each person’s situation. Now, in many cases, a loan with the lowest APR is beneficial because it means you’ll pay less to borrow over time. But sometimes, a loan offer that comes with a lower APR requires you to pay mortgage points or extra fees. If that’s the case, a slightly higher APR that doesn’t have mortgage points or other fees tied to it may be a better option.
Additionally, the annual percentage rate will change based on the type of loan you take out.
Types of APR for mortgage loans
Most likely, you’ll either have a fixed APR or a variable APR. These are the two main types of APR that bank loans generally come with. The specific terms and rates fluctuate depending on which type the APR falls into.
So, let’s go over each one.
A fixed annual percentage rate means that the rate won’t change during the life of the loan. This is appealing to many prospective homebuyers because it enables predictable budgeting.
With a fixed APR, you won't have to account for an unforeseen rise in your monthly payments due to market interest rates increasing. On the other hand, if market rates fall below what they were when you received your loan, you’ll still have to pay the higher rate.
The APR is an especially important factor to consider on variable loans. This is because its rate can change as it’s tied to an index interest rate. Now, it’s true that the APR may fluctuate in your favor if the market interest rate drops. But, this isn’t guaranteed. As a result, choosing a loan with a variable APR can be a bit of a gamble.
So, which APR is better? As stated, fixed APRs and variable APRs each have their advantages and risks. It’s up to you to determine which type works better for your situation.
Besides the type of APR you get, other factors will influence what rate you receive as well.
What factors affect your APR?
If the market rates are at an all-time low and you choose a fixed APR, you may still wonder, “why is my loan APR so high?”. This is because your APR is also affected by other factors.
Technically, your lender can determine what interest rate to offer you on the loan. And, because the interest rate is included in the APR calculation, it can have a significant impact on your APR.
When setting your interest rate, your lender will look at your credit score, the prime interest rate, and the competing rates in the market.
It’s important to note that paying your APR on time or paying it in full won’t matter in terms of the rate changing.
How do you calculate your APR?
The APR formula is easy to calculate on your own. Simply, multiply the periodic interest rate by the number of periods in a year for which the rate is applied. We’ll break this down into steps to give you a clearer idea of how to calculate it.
1. Add the total interest to be paid over the life of the loan + all fees included.
2. Divide that sum by the loan amount.
3. Divide that quotient by the total days in the loan’s term.
4. Multiply that quotient by 365.
5. Multiply that product by 100 to see the APR as a percentage.
How does the APR compare to other rates?
Because the APR is considered the most important factor when browsing loans, it’s important to understand how it compares to other rates.
Nominal Interest Rate
The nominal interest rate reflects the interest rate without taking inflation into account. This rate also doesn’t include other expenses accrued by the borrower. Thus, your APR will likely be higher than the loan’s nominal interest rate.
Daily Periodic Rate
The daily periodic rate shows how much interest accrues when it compounds on a loan more than once a year. This rate is calculated by the interest charged daily divided by the total days in a year. In other words, it’s the APR divided by 365.
Considered the most important factor, the APR still has its disadvantages when used as a tool to compare loans. The two main drawbacks are related to its accuracy and adjustable-rate mortgages.
It may not be 100% accurate
It’s important to disclose that the APR won’t always give a 100% accurate reflection of the total cost of borrowing. This is because it assumes a long-term repayment schedule. Meaning it could underestimate the actual cost of a loan.
For example, a 30-year mortgage will have smaller monthly payments than a 10-year mortgage since the payments are spread out over a longer-term. But, you’ll pay more in interest over the life of the loan.
Adjustable-rate mortgages (ARMs)
The interest rate on ARMs changes once the fixed-rate period ends. But, annual percentage rates are based on fixed rates. This means that the APR may understate the true borrowing cost.
So, when taking out an ARM, calculate the APR based on the maximum interest rate possible at each adjustment. This will ensure you're not surprised if you see an increase in your monthly payments.
Find the best mortgage APR
At the end of the day, your APR is considered the most important factor when comparing mortgage options. It’s the best indicator for providing a broad measure of how much it'll cost to take out a loan.
Want to make sure you find the best mortgage APR? Contact one of our mortgage experts today. Our transparent process will ensure you find the best APR for your situation