When evaluating loan offers it’s important to understand the difference between the interest rate and the Annual Percentage Rate or APR. Companies are required by law to post the APR next to the interest rate because the interest rate alone is not necessarily an accurate expression of a loan’s cost. The interest rate is the percentage of the loan amount that the bank is charging you to borrow money.
The APR, by contrast, includes other costs of the loan (the upfront fees and any discount points) and calculates them as a yearly percentage of the loan amount. Because of this, APR is a more accurate representation of the true cost of a loan. It is a good idea to compare the APR of different loan offers to get an idea of which loan has the larger overall cost. Visit the GetSmart loan calculator Which mortgage is right for you for help running the numbers.
When there is a big difference between the interest rate and the APR, discount points (pre-paid interest) are often the reason. When you pay discount points, you are essentially paying the lender a portion of their interest income up front, in return for a lower interest rate over the life of the loan. A “point” equals 1 percent of the loan amount and will typically lower the interest rate by 0.125 percent. So if the interest rate is 6.5 percent, you could lower it to 6.375 percent by paying for one discount point.
Other fees included in the APR calculation
The origination fee and any other lending fees — think of these as the lender’s service charges – are included in the APR calculation. These fees can rack up, so they can be a useful point of comparison when deciding between lenders. Private mortgage insurance (PMI), which most lenders require if you have a down payment of less than 20 percent of the home’s value, is also included in the APR equation. There are other fees to getting a loan as well, but since these are third-party fees — assessed by companies other than the lender — they are not included in the APR.
Some things to remember about APR
The costs included in the APR are spread across the entire term of the loan, in most cases thirty years. Yet very few homeowners keep their mortgage this long. So if you refinance or move in five to seven years, the mortgage with high up-front costs may turn out to be more expensive than the APR suggests. Another thing to consider is that APR is less accurate for adjustable rate mortgages, since it’s impossible to predict what rates may do in the future. (Consider for instance that in 1980 the average interest rate for a 30 year fixed mortgage was over 13%, more than twice what it is today.)