When shopping for a home loan, you have probably come across the term APR.
The APR factors in the rate, closing costs, and other fees so you can easily see which loan offer is the cheapest.
We’re going to look at each term to explain the difference and show you how to calculate the APR on your loan.
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What is APR?
APR stands for the annual percentage rate on a loan. This is the amount you will pay annually, including interest, lender fees, origination fees, and other various fees. When borrowing money, the lower the APR is, the cheaper it will be over time, but it doesn’t mean you’ll have the lowest monthly payment.
Annual percentage rates give you a better idea of how much you’re really paying on your loan.
The APR can be higher or lower depending on if points are being added. Lenders will often advertise low APR rates that are artificially lower because discount points are required to be paid.
- Loan 1: $250,000 with a 5% interest rate and $4,000 in closing costs
- Loan 2: $250,000 with a 4.75% interest rate and $18,000 in closing costs
Even though the mortgage rate is lower on loan 2, you pay $14,000 more in closing costs. So the APR on loan 1 is 5.14% compared to 5.36% for loan 2, making it cheaper over time.
What is the Interest Rate?
Your annual interest rate is a basic look into just the interest you are being charged for a mortgage loan without taking other fees into account. Interest rates are lower than the APR, usually by a few tenths of a percentage point.
Most people shop for lenders and use the interest rate as a way to compare loan offers. By finding the lowest interest rate, you will get the lowest monthly mortgage payment. If you want to know the mortgage loan’s total cost, you should compare the APR rates quoted to you. The best APR may not be the best rate or lowest payment, but it will be the cheapest over the life of the loan.
APR vs. Interest Rate Comparison
The difference Between APR and Interest Rate is simple. APR is the loan’s true cost, while the interest rate is just the amount of interest you’ll pay.
The chart below is from BankRate; it shows the total costs and APR over the life of a $200,000 mortgage loan. 1.5 discount points are used, cut the rate by 0.25%, and added another 1.5 points would cut the rate by 0.50%.
How the APR is Calculated
Let’s say you have a fixed-rate mortgage for $100,000 with a 5% mortgage rate and $1,000 in closing costs. The monthly mortgage payment is $537.
Your other option is a 4.5% rate, with closing costs of $4,000.
Which is the better deal?
This is where knowing the APR comes in handy. The first loan has an APR of 5.09%, while the second loan has a 4.85% APR. This means that the second loan will save you the most money over time.
What Is More Important to You?
Having the lowest mortgage payment – If your main objective is to have the lowest monthly payment on your loan, you should be looking for the lowest interest rate. And because your payment will be lower, you will qualify for a more expensive house.
Paying the least amount over the life of the loan – Now you’re not really interested in having the lowest mortgage rate. You want to pay the least amount possible on your mortgage loan, then you should be looking for the lowest APR.
Getting a Lower Rate
Your credit score is the most important factor lenders use to know which rate they can offer. The higher your credit score, the lower the rate and APR will be. Make sure you maximize your credit score before applying for a loan to get the best rates.
If you’re shopping for a Government insured loan like an FHA loan, then you’re in luck. Government loans typically have slightly better rates than conventional loans.
Pay Down Your Credit Card Balances
The quickest and simplest way to increase your credit score in a hurry is by paying down the balances on your credit cards. The amount of available credit you have used up is called your credit utilization ratio, and it accounts for 30% of your overall score. Only your payment history (35%) has a bigger impact on your credit rating.
Try to pay down your credit card balances to less than 15% of the credit limit. This is the optimal credit utilization ratio to have the highest FICO score possible.