Mortgage terms can be confusing. But when you break them down into digestible pieces of information, they actually make sense. And the more informed you are, the greater the chance you’ll make a wise home-buying decision.
One term guilty of constantly confounding hapless homebuyers is APR. It stands for Annual Percentage Rate, and can be spotted in a mortgage rates table (thanks to the Truth in Lending Act) next to its partner in crime, the interest rate. While both terms share the prized percentage sign, they have an important distinction.
APR vs Interest Rate
It all has to do with fees. The interest rate is what it costs you to borrow money from your lender without fees. On the other hand, the APR is what it costs to borrow money from your lender with fees. This is why the APR is always higher than the basic interest rate.
So what are the fees?
Fees are a tricky beast. Different states, markets, and lenders all have their own variations, which make it harder to discern if you’re getting a good deal. As always, the more you know makes it less likely you’ll get swindled. At the very least, you should be aware of these basic fees.
Closing costs are miscellaneous fees paid to all parties involved with the sale of the home (e.g. lender processing loan, title company for handling the paperwork, a land surveyor, local government offices for recording the deed etc.). These costs can amount from anywhere between 1% and 8% of your loan amount, but usually fall between 2% and 5% of your loan amount.
Broker fees are just what they sound like: a fee charged for the service of a broker. Generally, the fee is between 1% and 2% of the loan amount. There shouldn’t be any surprises either, the broker is required to disclose all fees up front, and should be able to tell you exactly what each fee is for.
One advantage of choosing a direct lender, is you don’t have to pay for broker fees. Because with a direct lender, you are the one doing the labor, and therefore, don’t have to pay for the work the broker would be doing. There are still fees for processing the loan, but a broker may still be more expensive.
There are two types of mortgage points.
Discount points are prepaid interest on the mortgage loan. For every point, your mortgage rate drops down (usually .25%). Typically, borrowers can pay between 0 and 4 points. And because the Annual Percentage Rate is the total cost (mortgage rate + fees) of your mortgage, lowering your mortgage rate translates into a lower APR. Discount points are also tax-deductible.
The main takeaway is that by paying more up front, you get a lower interest rate. This is most useful a) if you have the available cash to put down, and b) if you plan on staying in your home long term. If you’re trying to pay the lowest possible price upfront, then choose the zero-point option.
Origination points exist so the lender can cover the cost of evaluating, processing, and approving your mortgage. They are not set in stone, so depending on your lender, you might be able to negotiate the number of points.
Back to the APR
If two loans are set for the same period of time, the borrower can compare APRs, or interest rates, and find out which loan is the better deal. For example, a loan with a 3 percent interest rate will have a lower monthly payment than with a 5 percent interest rate. Similarly, a loan with a 3 percent APR will have a lower total cost than it would with a 5 percent APR.
It’s important to note that APR assumes you will stay in your home for the full duration of the loan. And since it would be impossible to factor in whether or not a borrower will refinance, it assumes the borrower will not. If that wasn’t enough, it also assumes that the borrower doesn’t make any extra payments toward their mortgage. These assumptions are why some say that APR can be misleading.
Things can also get a little tricky when you take into consideration the fact that most homeowners only end up staying in their home for a relatively short period of time. What’s the big deal? Well, a loan with a higher APR actually has lower costs over the first few years (because you didn’t pay for discount points, which would have lowered your APR).
So if you know you’re only going to stay in a home for a little while, a higher APR would be your best bet. But if you know you’re going to stay in your home for the entire life of the loan, the lower APR is what you want (because over time, paying upfront for the discount points to lower your interest rate will save you money).
It can definitely get complicated when you plan on staying longer than a few years, but not for the whole life of the loan. With situations like that, it pays to have a competent lender who will help you work out which loan is best.
The bottom line:
When searching for the best deal on a mortgage, comparing APRs, due to some possibly false assumptions (e.g. not refinancing, no extra mortgage payments, staying for the full life of the loan), might not be as prudent as say, comparing mortgage rates and fees.
But if you still want to exercise all options, and choose to compare APRs, it’s crucial that you take into consideration how long you plan on staying in your home. Also, because some of the calculations can be complex, make sure you choose a lender that is willing to walk you through the math.