This question comes up a lot in Zillow Advice, so this post will help explain the difference between interest rate and APR (Annual Percentage Rate). Basically, think of the interest rate as the starting point in what you will pay for a mortgage loan and then, tack on associated fees to calculate the APR.
Let’s begin with some definitions:
What is the interest rate?
The interest rate is the percentage of the loan amount that is charged for borrowing money. We can consider this the base fee. It is very important when comparing loan quotes since it directly affects monthly payments.
What is the APR (Annual Percentage Rate)?
The APR is a calculated rate that not only includes the interest rate but also takes into account other lender fees required to finance the loan. The idea behind APR is to help consumers understand the tradeoffs between interest rate and the fees paid at closing (such as paying higher fees to lower interest rates or increasing interest rates to cover closing costs). The government thought this was important so they required it to be shown next to the interest rate as part of the Truth in Lending Act.
Here is a diagram showing how APR tries to balance interest rate and fees:
How APR is calculated
Conceptually:
To calculate the APR, the lender fees (fees required to finance the loan) are incorporated into the interest rate. This is done by amortizing the fees out over the life of the loan as if they were additional payments, and then calculating a new rate.
Specifically: (feel free to skip this paragraph)
The fees are added to the original loan amount ($200,000 + $3,000) to create a new loan amount ($203,000). This new loan amount, along with the interest rate (5.00%), is used to calculate a new monthly payment ($1089.75). The APR is then calculated by working backwards to figure out what the rate would have to be for a loan with the new monthly payment ($1089.75) and the original loan amount ($200,000). This is your APR (5.13%). The APR is typically higher than the interest rate because it includes the fees.
Limitations of APR
As useful as the APR can be, it has its limitations. APR spreads the fees paid upfront over the life of the loan. So the comparison of APR is only accurate if you plan to keep the mortgage for the entire length of the loan. Since most borrowers do not keep their loan for the full period (they typically refinance or move), the APR can make some loans look artificially better. In the example above, if you only kept the loan for 3 years, the second loan would be much more expensive even though it has a lower APR. This is because the $6,000 in fees is paid upfront whereas the higher interest rate in the first loan is amortized over the life of the loan. See my post on whether or not you should pay points to learn more about the tradeoffs of paying interest upfront versus over the life of the loan.
The other problem with APR calculations is that different lenders may include different fees in their APR calculations for various loan programs. Remember to always ask your lender what is included and not included in your APR.
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- Categories: Costs and Fees, Mortgage Rates
Comments
11 Comments so far
Brian Brady
“So the comparison of APR is only accurate if you plan to keep the mortgage for the entire length of the loan. Since most borrowers do not keep their loan for the full period (they typically refinance or move), the APR can make some loans look artificially better.”
BINGO!
This might be one of the first times I’ve heard a non-industry author articulate this glaring limitation correctly. Consumers would do well to “accept and sign” the government-mandated disclosure but demand additional TILA disclosures, computed to the expected hold time, for a more accurate analysis.
Justin McHood
Nate, way to flex your mortgage muscles! This is an excellent, clear-cut, easy-to-understand guide to APR.
I am just going to print this out (along with Brian’s comment) and hand it to people when they ask me about this topic.
Justin
Kiran
When is it the case that the advertised rate is higher than the advertised APR?
What about 5/1 or other ARM loans? Does the advertised APR reflect expected changes in the underlying index over the next 30 years?
Nate Moch
Kiran,
Good question. Yes, the advertised rate can be higher than the APR. This can happen on ARM loans when index rates are low (you can see this in the current marketplace).
For ARM loans, APR is calculated using different rates. The stated interest rate is used for the locked period of the ARM. For a 5/1 ARM this would be 5 years. However, for the remaining 25 years, the calculation uses the current value of the underlying index plus the margin. When the index rate is extremely low, the readjustment can bring down the APR below the initial rate.
Unfortunately, the APR calculation does not reflect expected changes in the underlying index over the life of the loan. It assumes that the index stays the same (which we know will not be the case!). This is another big limitation of the APR calculation for adjustable rate mortgages.
Hope that helps,
Nate
Kiran
Thanks for your explanation!
sam
Nate,
Can you confirm this?
1. If you are planning to stay for the full length of loan period in the house and if if I am looking for fixed rate loans.. I should pay attention to APR.
2. If I am looking for the 7/1 arm as I am not sure if i will stay for long in my current, I should pay attention to the interest rate
3. If I am comparing the total monthly cost between fixed and arm, I should compare the interest rate and not the APR. I understand that I will have to account for the fees and closing costs seperately.
Ramala Jones
Some helpful tips of avoiding paying more interest is to put money down which would lower that 100,000, also to pay extra on your mortgage which lowers the principal amount and basically you are calculating interest on a lower amount which means a lower amount of interest would add up. Another thing that could save you a lot of money on your mortgage in interest is to make your payment more frequently. For example if you pay 1000 a month on your mortgage, pay 500 every two weeks which equals the same amount of money you are paying monthly, but this lowers the amount of interest because you pay interest on interest so the more frequent your payment the lower your principal balance and the lower the daily amount of interest will be.
Loan Modification
Thanks for sharing this info post with us.
How to Compare Quotes and Trade Off between Interest Rate and Fees | Free FHA Loan Advice
[...] Problem with APR An initial solution, the Annual Percentage Rate (APR), was devised as way to help borrowers compare quotes. However, the APR calculation for Adjustable [...]
Long Duan
Quote: “The fees are added to the original loan amount ($200,000 + $3,000) to create a new loan amount ($203,000). This new loan amount, along with the interest rate (5.00%), is used to calculate a new monthly payment ($1089.75). The APR is then calculated by working backwards to figure out what the rate would have to be for a loan with the new monthly payment ($1089.75) and the original loan amount ($200,000).”
I don’t quite understand this part. It seems that the $3,000 fee is also generating interests that has to be paid by the consumer. However, isn’t that customer paid the $3,000 fee at the closing (i.e., as a part of the closing cost)? If yes, they why does the customer has to pay the interests for that for the next 30 years?
A.
Thank you for a great article - it made me realize that there are two completely different types of fees associated with a mortgage loan: the closing charges (not included in APR), and the servicing costs (included in the APR) - silly me thought the servicing costs would be taken out of all that interest that a lender is earning on my loan!