"APR" stands for annual percentage rate. The APR is a much better indicator than just the interest rate of the actual cost of a mortgage loan, as it estimates what you'll pay over the course of an entire year. The Federal Truth in Lending law requires mortgage companies to list the APR of their loans when they advertise an interest rate. This prevents them from advertising unduly low interest rates and tacking on fees and other costs that drive up the real cost of the loan.
The APR therefore takes into consideration other fees and costs including:
Discount points. Commonly referred to simply as "points," these are increments of 1 percent of the mortgage that you pay off at the closing. If points are not required, and you elect to pay off points to lower your interest rate, it will not be included in the APR. However, if you're required to pay off points, this cost will be factored in when your APR is calculated.
Origination fees. Often confused with points, this is a fee the lender charges for work they perform on the borrower's behalf.
Mortgage insurance premiums. This is insurance against defaulting on payment of the loan. Your lender may require you to pay mortgage insurance if your down payment is less than 20 percent of the selling price of the home.
Prepaid mortgage interest. Since interest is generally paid on a monthly basis, prepaid mortgage interest is paid at closing to cover the gap between the time you close and the first of the next month.
The APR your lender quotes you will include other fees too, but APR doesn't tell the whole story. There are other fees and costs, such as title insurance, that are still not included in the calculation. And in the end, APR is nothing more than an estimate of the various costs of your loan, including the interest rate. It is not an exact science, since some of the numbers will vary between the time of calculation and the time of closing. Nonetheless, it’s a step in the right direction, and one place to start when comparing lenders and the loans they offer.
To show how the APR can be used for comparison purposes, here’s a simple example. You are shopping for a 30-year mortgage for $100,000.
- Bank “A” offers a 30-year fixed mortgage at a 6 percent interest rate.
- Bank “B” quotes a 30-year fixed mortgage at a 5 percent rate.
Your first instinct would be to go with Bank “B” because of the lower rate. However, Bank “B” charges a $2,000 origination fee, and you are required to pay four points, or $4,000, on your $100,000 loan. Bank “A” has no origination fee, and requires you to pay no points. Suddenly you will be paying $6,000 more if you go with bank “B”. The APR will factor this into the overall equation, and Bank “A” will have the lower, and potentially more attractive, APR.
Many Internet sites have APR calculators where you can enter various fees and determine which loan appears better for your purposes. Remember to compare similar loans, such as two 30-year fixed mortgages.