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Choosing the right mortgage can help you save money and feel more comfortable with your monthly housing expense.
One thing you’ll need to know when you shop for a mortgage is how to compare a mortgage interest rate and an annual percentage rate (APR).
What are mortgage interest rates and APRs?
A mortgage interest rate is a small percentage that’s applied to your loan balance to determine how much interest you owe your lender each month. When you begin to repay your loan, your rate will be used to calculate the interest portion of your monthly payment.
For example, if you owe $100,000 and your interest rate is 5 percent, your annual interest expense will be $5,000, and you’ll pay a portion of that every month as part of your mortgage payment. While the calculations are actually more complicated than that, this example helps explain the general concept.
An APR is also a percentage, but it also includes all the costs of financing, including the fees and charges that you have to pay to get the loan. The APR for a given loan is typically higher than the mortgage interest rate. An APR is never used to calculate your monthly payment.
Understanding mortgage interest rates
A mortgage payment is made up of the principal and the interest. The principal is the money you borrowed from your lender. The interest is a percentage-based fee that you pay the lender for borrowing that money. Paying the principal reduces the amount you owe, while paying the interest does not.
Rates can be fixed or adjustable. A fixed rate never changes, but the rate for an adjustable rate mortgage (an “ARM”) can adjust higher or lower (based on an index) while you have your loan. If your rate adjusts, your monthly payment will change. Adjustable rate mortgages typically have caps that limit how much and how often they can change. Most adjustable rate mortgages have a rate that’s fixed for a number of years and then can adjust.
Lenders offer different rates to different borrowers. The rates you’ll be offered typically depend on the following:
- How much you want to borrow.
- How much you’ve saved to pay upfront.
- How many years you’ll have to repay your loan.
- Whether you usually pay your bills on time.
- The type of loan you choose.
- Where you live.
When you apply for a loan, the rates you’re offered can be either floating or locked. A floating rate can change before you close your loan. A locked rate shouldn’t change for 30, 45 or 60 days, depending on how long your rate lock lasts. If you won’t be able to find a home and complete the loan process in that time frame, you can usually pay a fee to get a longer lock.
An APR includes both the mortgage interest rate you pay for the loan as well as some of the fees the lender charges you to get the loan. There could also be other costs that you’d have to pay that aren’t included in the APR. Which costs are included depends on how the lender calculates APR. For example, the lender’s fees usually are included, but the appraisal fee usually isn’t.
An APR can be used as a “guiding point” to understand the costs associated with a fixed-rate loan, but it’s not the only factor that’s important, says Jim Sahnger, a mortgage planner at Schaffer Mortgage Corp. in Palm Beach Gardens, Florida.
“People should pay attention to APR, but they should also pay attention to the total cost associated with getting the mortgage,” Sahnger says.
How to compare mortgage interest rates and APRs
When you review your Loan Estimates and evaluate your options, remember not to compare a mortgage rate to an APR because that’s not an apples-to-apples comparison. Instead, always compare rates to rates and APRs to APRs.
It’s important to compare rates because the interest you pay is a big part of your monthly payment. With a lower rate, you’ll pay less interest over the life of the loan.
It’s important to compare APRs because interest isn’t the only cost you’ll pay for your loan.
APRs are more useful to compare for fixed-rate loans than they are for variable-rate loans. This is because variable-rate APRs are partly based on assumptions about future rate adjustments. Because the adjustments are not certain, a variable-rate APR might not include the loan’s highest possible rate.
Never compare an APR for a loan with mortgage insurance to an APR for a loan without mortgage insurance. Mortgage insurance protects your lender if you don’t repay your loan. You may have to pay for it if your down payment isn’t at least 20 percent of your home’s purchase price.
A loan with mortgage insurance will have a higher APR than the same loan without mortgage insurance because the insurance is a cost that’s included in APR.
When shopping for a mortgage, look at not only the interest rate and APR, but also the other costs of the loan that aren’t included in APR. Ask your lender how it calculates APR and what costs are included, and read the information you receive from the lender.