APR versus interest rate
When lenders advertise mortgage rates, they are required to display an additional number called the annual percentage rate, or APR.
The advertised rate is the one used to calculate your mortgage payment. Borrow $100,000 at five percent with a 30-year term, and the payment is $537. But an advertised rate tells you nothing about the cost of the loan or if it's a good deal. Suppose you're offered two loans. Both have a five percent rate, but one costs $1,000 and the other costs $4,000. They're obviously not the same!
How is APR calculated?
In the example above, the payment for both loans is $537 per month. But because the first loan costs $1,000, you're only actually getting $99,000 for that $537 monthly payment. When you pay $537 a month to borrow $99,000 the rate is 5.09 percent. The second loan costs $4,000, so for your $537 a month, you only get to borrow $96,000. In that case, the APR is 5.35%.
You don't really need an APR calculation to tell you that the first loan is the better deal - it's pretty obvious. But what if a five percent loan costs $1,000 but a 4.5 percent loan costs $4,000? Which is a better deal? That's where APR comes in. The APR of the five percent loan in this case is 5.09 percent. The APR for the second loan is 4.85 percent. That means over the life of the loan, the second loan costs less than the first loan.
Is the loan with the lowest APR always the best?
Many people think that the loan with the lowest APR is automatically the best deal. That's not true unless you keep your mortgage for its entire term. If not, the upfront costs of getting your mortgage are spread out over a shorter period of time, and that changes the true cost of the loan. Look at our two $100,000 30-year fixed loans again, but this time we'll assume that you'll sell the home in five years.
When you change the first loan's term from 30 years to five years, its APR increases from 5.09 percent to 5.41 percent. And the second loan with its $4,000 in costs? It increases from 4.85 percent to 6.12 percent!
ARMs
Because no one can predict how interest rates will change over the years, the APR for adjustable-rate mortgages is calculated on the assumption that the loan is adjusting at that time. So if you have a 5/1 mortgage starting at three percent, and if it were adjusting today its rate would be six percent, that's the rate used in the APR calculation. Even though it's highly unlikely that rates in five years will be exactly what they are today.
The most important thing to remember when comparing APRs of ARMs is that they are calculated based on current economic conditions. The APR of a loan on Monday may be different from the APR of that same loan on Friday. You need to get your mortgage quotes on the same day (preferably at the same time). This is easiest to manage by getting your quotes online.
