What Is an APR? Annual Percentage Rate, Explained
What is an APR? The annual percentage rate, or APR, is how much you'll pay in interest and other fees when you get a mortgage from a lender to buy a home. APR can also be considered the total cost for a debt over a one-year period.
The "and other fees" clause is key here. When home buyers get a loan, they often obsess over the interest rate alone—say, that 5% extra you'll pay over the life of your $300,000 loan. But that's not where your expenses end, and that's where APR comes into play.
"The APR includes the interest rate and other charges, which is why it's usually higher than just your interest rate," says Michele Lerner, author of "Home Buying: Tough Times, First Time, Any Time."
What is an APR, and which fees are included?
People tend to think of annual percentage rate as the "true" amount they pay, because it includes all of the major fees associated with the loan (e.g., closing costs, points, and private mortgage insurance).
The APR is also your "apples to apples" number when comparing loans from various lenders, and keeps you from getting tricked into paying hidden fees. If one lender has a vastly higher APR for the same interest rate, that means it's charging you more to get the loan and you could end up carrying more debt.
There are some costs that aren't usually calculated into APR, including the home appraisal, title search, title insurance, credit report, and transfer taxes. (Though taxes are usually considered part of closing costs, they aren't a lender fee so don't count toward the APR.)
That said, the appraisal, credit report, title search, and title insurance should normally be fairly minor costs when compared with the cost of the loan. Still, if you're looking at two very close rates, make sure to examine what's calculated into the APR. Some lenders might not be including things that other lenders are.
Interest rate vs. APR
So which number is more important, the interest rate or APR? If you want to make sure you get the best loan for your situation and don't get into too much debt, it's important to look at both.
"The reason you should look at both numbers is that if you just stick to the interest rate, you may not know about the fees associated with your loan," explains Lerner. "If you focus only on the APR, you could miss out on a lower interest rate."
Keep in mind that the fees that are included in the APR are paid at closing. In contrast, your interest rate is what you'll pay over the life of your loan, which could last as long as 30 years, notes Stephen Rybak, a senior vice president with Guardhill Financial in New York.
What determines my interest rate?
Even saving a fraction of a percent on your interest rate can save you thousands of dollars.
Six key factors affect your interest rate:
- Credit score: Your credit score is a numerical representation of your track record of paying off your debts, from credit cards to college loans. Lenders use your credit score to predict how reliable you’ll be in paying your home loan. In general, consumers with higher credit scores receive lower interest rates than consumers with lower credit scores. A perfect credit score is 850, a good score is from 700 to 759, and a fair score is from 650 to 699.
- Loan amount and down payment: If you're willing and able to invest a large down payment in your home, lenders assume less risk and will offer you a better rate. (A 20% down payment makes a lender feel a lot more secure than a 10% down payment.) If you don’t have enough money to put down 20% on your mortgage, you will probably have to pay private mortgage insurance, or PMI, an extra monthly fee meant to mitigate the risk to the lender that you might default on your loan. (PMI ranges from about 0.3% to 1.15% of your home loan.) Also, depending on your circumstances or loan type, your closing costs and mortgage insurance may be included in the amount of your loan.
- Home location: Mortgage rates can vary depending on where you’re buying a home. Indeed, the strength of your local housing market can drive up or drive down interest rates.
- Loan type: Your interest rate will depend on what type of loan you choose. The most common type of home loan is a conventional mortgage, aimed at borrowers who have well-established credit, solid assets, and steady income. If your finances aren't in great shape, you may be able to qualify for a Federal Housing Administratin loan, a government-backed loan that requires a low down payment of 3.5%. There are also U.S. Department of Veterans Affairs loans and U.S. Departmentof Agriculture Rural Development loans.
- Loan term: The duration of your loan affects your rate. In general, shorter-term loans have lower interest rates—and lower overall costs—but larger monthly payments.
- Type of interest rate: Mortgage rates depend on whether you get a fixed-rate mortgage of an adjustable-rate mortgage, or ARM. "Fixed-rate" means the interest rate you pay remains fixed at the same level throughout the life of your loan. Meanwhile, an ARM is a loan that starts out at a fixed, predetermined interest rate—likely lower than what you would get with a comparable fixed-rate mortgage—but the rate adjusts after a specified initial period—usually three, five, seven, or 10 years—based on market indexes.
How to choose a home loan that's right for you
Having a hard time choosing between loans based on the interest rate versus APR? If you have the cash upfront but would prefer to have a lower monthly mortgage payment, it might be worth it to you to shop for the lowest interest rate, even if the APR is slightly higher. In 10 years, you'll be thankful for that lower interest when you're paying a smaller bill.
On the other hand, if you need all your cash on hand for the down payment, you might need to pay a slightly higher interest rate with fewer fees at closing. It also matters how long you plan to stay in the house.
Every loan has a break-even point, where the extra fees you paid upfront are balanced out by a lower interest rate. If your break-even point for a higher-APR/lower-interest-rate loan is seven years, but you plan to sell the house in five, you're getting a better deal with a higher-interest-rate/lower-fee loan.
In the end, to get the best deal on a home loan, you'll want to look at the interest rate, APR, and any details you can get about what fees have been included (or perhaps more importantly, not included) in those numbers.
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