Shopping for a mortgage can be daunting, there is a lot to learn and plenty of decisions to make. What monthly payment can you afford? Should you choose a fixed or adjustable rate? One factor that most people do not consider is the APR, or Annual Percentage Rate, compared to the mortgage interest rate. In fact, many do not even realize that the mortgage interest rate and APR are two different things, and that can be a costly oversight.
What is the Interest Rate?
The interest rate is what the lender uses to determine your monthly payment. You will have the choice between an adjustable interest rate, one that typically changes once per year, and a fixed interest rate that remains the same throughout the entirety of the loan. A fixed interest rate will allow your monthly payment to remain at the same amount, while an adjustable rate causes fluctuations in the amount you pay monthly (for better or worse).
One of the largest and most common mistakes borrowers make is to focus only on keeping their monthly payment down, which can mean they are paying higher price for their mortgage in the long run. It comes as a surprise to many that higher interest rate may be the more economical choice because it can provide a lower APR.
What is the APR?
The APR or Annual Percentage Rate is the total cost of the mortgage over the lifespan of the loan. This figure combines the mortgage interest rate as well as all fees paid on the loan over it’s lifespan. Fees and closing costs affect your APR. Higher fees mean a higher APR, obversely a higher APR means higher fees.
In order to determine what you will pay over the life of the loan you must factor in the APR, however it does not have any affect on your monthly payment. The APR gives you a clear understanding of the total cost of the loan if you were to keep it for the entire term.
Comparing the APR against the Mortgage Interest Rate.
Now that you understand the difference between these two factors you can determine if a lower interest rate or lower APR will be most beneficial for your unique situation.
The main consideration is how long you intend to stay in the home. If you have found your perfect, forever home then you’ll want to pay less over the life of the mortgage, so paying the fees to secure a lower interest is most often going to be the right choice.
However if you are planning on moving in less than 5 years it becomes hard to justify paying the high cost of closing fees because you’ll have a much higher APR. Paying the lower interest rate doesn’t make much sense when you are not going to see the end of the long term.
Finding Your Break-Even Point
What matters in the end is how long it will take you to pay the closing costs on your mortgage. This is your break-even point. If were to take 15 years to pay off those costs, but you only plan on spending 10 years in the home then ask your lender if you can get a higher interest rate in exchange for fewer closing costs. However, if you plan on staying in the house for the next 20 years, paying the fees and securing a lower interest rate will lower your APR and the total cost of the loan.
When shopping for a mortgage you need to consider the whole picture. Closing costs, origination fees, discount points, and the total time you expect to be in the home all factor into the total cost. A temporary home means less time to spread these costs out and a higher APR, while a long-term home allows the costs to be paid over time resulting in a lower APR.
A Word to the Wise
When comparing mortgages ask your lender which costs are included in the APR as it can vary from one lender to another. You can not make informed decision without knowing exactly what you’re getting into.