The interest rate versus the annual percentage rate

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When applying for a mortgage, potential borrowers can consider two terms that can be used interchangeably: the interest rate and the annual percentage rate. They sound like the same thing but are, in fact, very different.

Confusion over terms often returns during the busy spring home shopping season. “People always ask me what [the APR] means, ”says Mathew Carson, a mortgage broker with First Capital Group, based in San Francisco, Calif.

The interest rate reflects the base cost of borrowing money and is a percentage of the principal amount of the loan. For example, the average interest rate for a 30-year fixed-rate jumbo mortgage was 4.04% for the week ending May 15, according to HSH.com, a mortgage website. In this case, a borrower with a mortgage of $ 1 million would have a monthly payment of $ 4,797. (The payment is amortized based on the amount and term of the loan, but does not include escrow for property taxes or home insurance.)

The Annual Percentage Rate (APR) takes the base interest rate and adds other costs for obtaining a loan, including mortgage brokerage fees, discount points (prepaid interest) and closing costs. Since additional charges are factored in, the APR is usually a quarter to a half point higher than the interest rate.

The borrower’s monthly payment is always the same, but the higher APR rate reflects the true cost of a loan. This figure gives borrowers a way to compare lenders using both the interest rate and the fee structure to see which loan is more expensive, says Diane Thompson, senior advisor in the Consumer Financial Protection regulatory office. Bureau, a government agency that enforces laws on consumers. loan rules.

Ms. Thompson likens the APR to an energy efficiency rating for a refrigerator. “Typically, the APR gives us a way to measure the lifetime cost of what the loan is likely to be,” she adds.

Not all of the costs of a mortgage loan are included in calculating the APR, but it usually includes discount and origination points, prepaid interest, administrative fees, loan processing fees, fees. underwriting, document preparation fees, private mortgage insurance premium and escrow / settlement fees, says John Walsh, CEO of Total Mortgage, based in Milford, Connecticut, which lends in 33 states.

The APR gives borrowers a way to compare lenders to see which loan is the most expensive.

Loan application fees and credit life insurance, which pays off the mortgage in the event of a borrower’s death, may be included in the APR, he adds.

Fees normally not included in the APR include fees for title, attorneys, notary, document preparation, home inspection, registration fees, transfer taxes, a credit report, and a valuation of the house, Mr. Walsh said.

Closing costs can vary widely from lender to lender, says Walsh. So a lender may offer a lower interest rate but have a higher APR because of the higher closing costs, he adds.

The APR also provides an easy way to compare costs for different loan amounts, a larger or smaller down payment, as well as refinancing or a home equity loan / line of credit, Ms. Thompson says.

However, APR doesn’t always tell the whole cost story. Borrowers should also keep in mind that many lenders today offer credit to offset closing costs, which is often not included in the good faith estimate, says Carson. The APR evenly distributes the costs over the life of the loan. Thus, the APR will not reflect the real cost of a 30-year loan repaid in 20 years.

Here are some additional considerations.

• ARM headaches. The estimated APR can be misleading for a variable rate home loan (ARM), especially since interest rates are currently very low. For example, the average interest rate for a five-year adjustable rate mortgage was 2.98% for the week ending May 15, according to HSH.com. But, hypothetically, if mortgage rates jumped to 6% when the original five-year loan term expires, a borrower can end up with much higher house payments. “What APR [for an adjustable-rate mortgage] doesn’t really suggest it’s the risk, ”says Thompson.

• Other factors. While the costs reflected in an APR are significant, consumers should consider a variety of factors when comparing mortgages, including the length of the loan, the amount of monthly payments, and their tolerance for risk, Thompson says. Borrowers can also reduce the lifetime cost of a loan by prepaying closing costs instead of building them into the loan.

• New form soon. As of August 1, lenders are required to use new forms created by the CFPB that aim to make it easier for borrowers to find and understand the terms of their loan. For those who obtain a variable rate loan, the form provides the minimum and maximum payments projected over the life of the loan. The documents also detail closing costs and indicate third-party services borrowers can look for. For example, many borrowers stick with a title insurance policy designated by the lender, but the rates can differ significantly from provider to provider.

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