APR Unveiled: Your Key to Comparing Loan Options
Certified Financial Counselor
Ashley Altus is a writer and certified financial counselor through the National Association of Certified Credit Counselors.
See full bio
If you’re looking to buy a home, you’ve probably heard a lot about interest rates. It’s no surprise, as finding an affordable loan in the midst of rising market interest rates can help save you hundreds of dollars on an annual basis.
There's no question that it’s important to keep an eye on interest rates when you look for a mortgage, but they arent the only number to watch. A mortgage loan’s annual percentage rate can make a big difference when it comes to your monthly mortgage payment. Without looking at it as you evaluate your borrowing options, you could be fooled into thinking the cost of borrowing is lower than it actually is.
What Is Annual Percentage Rate (APR)?
To start with, the annual percentage rate is a percentage that details the actual cost of borrowing shown as a yearly rate. APR includes the interest rate plus any fees a borrower needs to pay the mortgage lender for the loan.
APR is not to be mistaken for annual percentage yield. While these sound similar, the annual percentage yield refers to the amount of compound interest you earn on an investment or savings. Essentially, one is money you owe and the other is money you earn.
How Does Annual Percentage Rate Play A Role When Comparing Loan Options?
Understanding a loan’s annual percentage rate is critical when evaluating your loan options and the cost of borrowing over a period of time. You’ll want to compare apples to apples, in other words, interest rates to interest rates and APRs to APRs.
With this in mind, just because two loans from different lenders have the same interest rate, doesn’t mean they have the same APR. One lender may charge more in fees, which is why comparing interest rates alone doesn’t show the true cost of borrowing. With the APR, you can see the effective interest rate for a loan, or in other words, gauge a more accurate idea of your costs for the loan.
The type of loan also plays a role when comparing APRs. Loan programs offering adjustable-rate mortgages versus fixed-rate mortgages can cost you differently in the long-run, even if both loans have the same introductory rate. For example, interest rates on adjustable-rate mortgages fluctuate over time. Learning how different types of loans work can help with selecting the best option for your situation.
How Is Annual Percentage Rate Calculated?
When you take out a mortgage, there are additional costs to pay besides just the loan’s annual interest rate. A mortgage rate’s annual percentage rate can be broken down into the following:
The mortgage interest rate is the cost a lender charges a borrower for a loan. It’s expressed as a percentage of the loan principal (the amount of money borrowed).
Lenders charge a wide range of fees to process and finance a mortgage. Some fees are included in the loan’s APR and others are not. Five common fees contained in the APR for a mortgage loan include discount points, closing costs, loan origination fees, broker fees, and private mortgage insurance (PMI).
- Discount points: Borrowers buy discount points, an upfront fee, to obtain a lower interest rate. Think of buying discount points as a trade-off. You’ll pay more in upfront costs for a lower interest rate, which translates to lower monthly payments and less money paid over the life of the loan.
- Closing costs: The APR does reflect most closing costs that will come with your loan, but not all of them. Appraisal fees, title fees, and home inspection fees, which can be part of closing costs, are not typically included in APR, whereas admin and other fees related to process the loan during closing are included.
- Loan origination fees: Lenders charge loan origination fees to underwrite, process, and fund the loan. Depending on the lender, you may also see these fees labeled as underwriting fees, lender fees, or administrative fees.
- Mortgage broker fees: If you use a mortgage broker to help find you a loan, you’ll end up paying for their service. Even if you aren’t paying them directly, expect the cost of their services to be included in the loan.
- Private mortgage insurance (PMI): If your down payment is less than 20%, most lenders will require borrowers to pay PMI. Lenders charge borrowers a monthly PMI to ensure that lenders have a safety net in case a borrower defaults on the mortgage. Depending on your credit score, the average PMI can range between 1.86-.58% of the loan amount, according to the Urban Institute.
What Impacts A Mortgage Loan’s Annual Percentage Rate?
Similar to interest rates, the annual rate for your loan is impacted by many factors. Market conditions can change the cost of borrowing on a daily basis. Mortgage APRs can vary based on the location of the home you’re trying to buy, loan amount, and loan term.
Mortgage lenders weigh your personal financial information, too. When evaluating your loan application, lenders perform credit inquiries to scrutinize your credit history and monthly statements from your financial institutions. They’ll be looking to see if you make on-time payments on a consistent basis and have a low credit utilization rate (to see you haven’t overextended yourself and taken on too much credit card debt).
Additionally, your overall credit score can also impact your rate; the higher your credit score, the more favorable interest rate and APR you are likely to receive. Late payments and large amounts of debt are factors that can drag down your credit score and impact your interest rate.
What’s Considered A Good APR?
Just like with an interest rate, the higher the APR, the more expensive it is to borrow money. As mentioned above, lenders reward borrowers with excellent credit scores with the lowest rates, and borrowers with bad credit scores should expect to see higher loan rates.
You’ll also see a range of rates depending on the types of credit. The average APRs for mortgage loans, auto loans, personal loans, cash advances, and credit cards will all be different from one another.
Even though current market rates impact your APR, there are some things in your control that can help you qualify for a prime rate, like focusing on your credit file. Making on-time payments, avoiding a high credit card balance, and paying off debt can help clean up any negative credit activity to keep your credit report in tip-top shape.
The Bottom Line
For a complete measure of what exactly a mortgage will cost you, look beyond the interest rate for the best loan deal. As you start collecting loan documents to apply for a mortgage, the APR holds the key to understanding the actual borrowing costs. Review it so you can make an informed decision, as it can greatly impact your yearly cost and monthly mortgage payment.