What Is Annual Percentage Rate (APR)?
Annual percentage rate is the annual rate you pay to borrow money or what you earn each year on an investment. APR better represents the true cost of a loan than an interest rate as it includes fees and other costs. An APR can be used to make better comparisons between loan options than interest rate alone. In general, an APR is about 0.20% to 0.25% higher than the interest rate.
It usually makes sense to choose a mortgage with a lower APR, but a loan with a better APR may require paying more points or additional fees. On the other hand, choosing a loan with a slightly higher APR can be a better choice if the money would be better spent on a down payment.
What Is Included in an APR?
While the annual percentage rate is designed to give consumers a more realistic idea of their loan cost each year, you may not necessarily be comparing apples to apples when using the APR. This is because lenders do not need to include all costs you will pay in the calculated APR for a loan.
Many fees will not be included in the APR, including credit report fees, inspection fees, and appraisal fees. Each lender can choose how much they charge for credit reports. Fees that are included in the APR include origination fees, discount points, most closing costs, and mortgage insurance premiums, when necessary. Because mortgage insurance is included in the APR, be sure you aren’t comparing the APR of a loan with mortgage insurance against the APR of a loan without mortgage insurance.
An APR Assumes a Full-Term Loan
It’s also important to remember that a loan’s APR assumes you will keep the loan until it’s paid off without making additional payments. The APR on a 30-year fixed mortgage, for example, assumes you will keep the mortgage for 30 years and make only the scheduled monthly payments. Most people do not do this, of course.
This matters because a loan may have a low APR but high upfront fees and a lower interest rate. If you sell the home or refinance after 7 or 8 years, the cost of the upfront fees will not be spread over the life of the loan and your APR will actually be higher.
APR and Adjustable-Rate Mortgages
APR is only effective in terms of fixed-rate mortgages as the interest rate will remain the same for the entire loan term. The long-term costs of an adjustable-rate mortgage are impossible to predict with an interest rate that usually begins low but increases after 1 to 10 years.
A loan’s APR should be considered a starting point to compare mortgage quotes and understand the costs of a fixed-rate mortgage, but it is not the only important factor to consider. It’s also important to think about how long you plan to remain in the home when choosing a mortgage. High upfront fees and a low interest rate tend to work best if you will remain in the home for a long time, but a higher interest rate and lower upfront costs will probably work best if you will sell the home or refinance in the next five years.