If you’re interested in obtaining a mortgage, you’ve probably heard the term APR. But if you’re a novice to the mortgage process, you might not know what an APR is. An annual percentage rate (APR) is the amount you’ll pay in interest plus extra fees. Essentially, this amounts to the annual price for borrowing money from your lender.
When a borrower takes out a loan, they tend to focus on the interest rate alone. For example, a 5% interest rate for a $300,000 loan. But there are other expenses. This is why considering the APR is important.
The annual percentage rate includes the interest rate as well as additional fees, which are often higher than the interest rate itself.
What Fees Are Included?
You could consider the APR the “real” amount paid. This is because the APR includes all major fees such as mortgage insurance, mortgage points, and closing costs. Looking at the APR will also help you consider which lender to go with. If a lender is offering you a loan with a tremendously larger APR at the same rate of interest, then they are charging you more money for the loan.
Not all costs are lumped into the APR however. Title insurance, credit reports, and appraisals are typically paid separate from the APR. But these are generally low cost expenses. Nevertheless, you should always check what the APR includes when deciding on a lender.
The Differences between interest rates and APRs
Both the interest rate and APR are important in deciding on the best loan for you. One lender might be offering a low interest rate with high cost fees, while another lender might have a high interest rate with significantly lower fees. Don’t forget that these fees are usually paid during closing, but your interest rate is paid over the duration of your loan, which is commonly 30 years.
How is interest rate calculated?
The main factors for determining interest rate are:
- Credit score – Your credit score essentially displays your track record for paying off debts. Lenders use this as a way of determining the likelihood of you paying off your loan on time. Generally, borrowers with higher credit scores will be granted lower interest rates than those with low credit scores. Good credit scores range from 850 to 700, decent credit scores are 699 to 650. Anything below 650 is considered low.
- Property Location – The local market of the area you wish to live in can drastically affect your interest rate.
- Loan Program – The type of loan you wish to proceed with can affect your interest rate. Conventional loans are designed for those who have good credit, and solid income. FHA Loans are aimed at those who are in less fortunate financial situations, requiring a smaller down payment. VA Loans for military veterans are also an option that typically comes with a lower rate of interest.
- Amount – As a general rule of thumb, the more money you put down up front, the better your interest rate will be. This is because the more money put down, the less risk the lender takes in lending you money. In most cases, if your down payment is less than 20% of the total home’s cost, you will be required to pay private mortgage insurance.
- Duration of the Loan – A loan with a shorter duration usually has a smaller interest rate, but greater monthly payments.
- Type of interest rates – There are two types of interest when it comes to mortgages; fixed rate mortgages and adjustable rate mortgages. A fixed rate mortgage locks in your interest rate for the entire duration of your loan. An adjustable rate mortgage has an interest rate that fluctuates with the market. The rate could be really low one year, and really high the next.
Choosing the Right Loan
It’s not always easy to pick a loan when considering interest rates and APR. If you have enough cash and would prefer a lower monthly payment, you might be better off taking a loan with a low interest rate but a higher APR.
But if you need all the cash you have for your down payment, you might need to take a higher interest loan with a lower APR.
The length of time you plan to stay in a house is also important. If you’re going to break even at 10 years, but want to sell the home after 5, you’d be getting a better deal with a higher interest rate with a lower APR.