When comparing mortgages, many borrowers look to the interest rate to determine how much they will be paying each month to pay back their purchase of a new home. While important, interest rates are not the only number borrowers should be looking at when asking themselves: “How much mortgage can I afford?” Homebuyers should also look to the APR to determine if the home they plan on buying fits within their budget.
What is an Interest Rate?
An interest rate is typically well-understood by potential home buyers. It is the percentage of the principal that a lender charges the borrower to finance the loan. Every month, homeowners work to pay off their interest rates, along with the principal balance of their home loan, through their monthly mortgage payments. For example, if a lender is charging a 3% fixed-rate mortgage on a home purchased for $200,000, the borrower will pay back $6,000 in interest. In this example, the total cost of their mortgage is $206,000 over the lifetime of the mortgage.
Mortgage interest rates can fluctuate day-to-day and as economic conditions change. For homebuyers to get the best interest rate on their new home, they should compare mortgage interest rates offered by different mortgage lenders and mortgage brokers to ensure that they are getting the best offer. Interest rates can also vary depending on the borrower’s credit profile, with factors like credit score, repayment history, income, and other factors considered by the mortgage lender.
Interest rates are a great way to determine what the monthly costs of a mortgage will be. Unless the borrower cannot put a 20% down payment on the home, the monthly mortgage is only the interest rate and principal due. At the beginning of the mortgage period, a more substantial portion of the monthly payment goes towards paying down the interest, while the latter payments on the loan term go to the principal.
What is an APR?
The APR, or annual percentage rate, is similar to the interest rate and is how much the borrower will be paying back on their mortgage. APRs are often more accurate, however, as they include not only the interest rate but also discount points, fees, and other charges the borrower is responsible for. Defined by the Consumer Financial Protection Bureau, the APR is “a broader measure of the cost of borrowing money than the interest rate.” Because the APR includes all additional costs and fees associated with a mortgage, it helps borrowers more accurately determine what the true cost of borrowing is. Because of this, APRs are generally higher than the interest rate alone. APRs do not impact the monthly mortgage payments, which are based solely on interest rates and the principal balance.
In the case of variable interest rate mortgages, APRs generally do not reflect the actual loan cost as interest rates as after the initial interest rate term, the interest rate can increase or decrease after that. If the interest rate increases, the APR would increase too, while any decreases in the interest rate would have the same effect on the APR. Borrowers must keep this in mind as the APR isn’t reflective of the maximum interest rate borrowers may be required to pay. IN the comparison of APRs between fixed and variable rate mortgages, borrowers should keep in mind that even if a variable rate mortgage has a lower interest rate and upfront cost, throughout the lifetime of the loan, it may result in higher total payments and costs.
However, unlike interest rates that are dependent on factors such as the market and a homebuyer’s credit score, APRs are determined by the lenders themselves. APRs include lender-set fees and other costs that differ between lenders. The law requires lenders to disclose the APR in every loan agreement. It is important to keep in mind that some costs like credit reporting and appraisal fees are not required to be included in the APR.
APRs spread the cost of various fees throughout the length of the loan. For homebuyers who intend to remain in their new home for decades, it is worthwhile to get a loan with the lowest APR, which means they will be spending less on homeownership than a loan with a higher APR. Alternatively, homebuyers that do not intend to stay in a home long should opt for a loan with lower upfront costs even if the APR is higher because they will save more during their fewer years of ownership.
While interest rates and APR are similar in that they reflect the monthly cost of a home mortgage, APRs are more inclusive with all additional costs throughout the lifetime of the loan added in. APRs are not, however, the monthly payment that is due but help borrowers plan for and anticipate total expenses. The monthly payment due to lenders is solely the interest rate, principal, plus private mortgage insurance if the borrower puts down less than 20% on the initial payment.
