Interest Rate vs. APR – Understanding the Numbers
There are many different numbers involved when you are buying a house. Understanding what they are and how it impacts you is key to getting the deal that you are looking for. For example, many buyers are confused about the APR and interest rate.
Plenty of people believe they are the same thing and use the term interchangeably, but they are wrong. They are two different things and understanding how it works will help you compare apples to apples when shopping around for a mortgage.
Understanding the Interest Rate
The interest rate is the rate of money that you are going to pay in order to borrow the money for your mortgage. It is a percentage of the purchase price. This is the base fee that you will be paying to be able to obtain a mortgage.
Understanding the APR
APR stands for annual percentage rate. The APR is a total of the interest rate and the other fees that the buyer pays the mortgage lender to obtain the mortgage. The Government requires in the Truth in Lending Act that all buyers be made aware of their APR.
This number can help buyers compare one loan to the next. They are able to determine if the lower interest rate is actually the better option once the higher fees are calculated in. The APR levels the playing field on helping buyers to compare loans and lenders.
How the APR Works
When a lender is calculating the APR they take the amount of fees that the buyer is paying to obtain the loan and split it up over the life of the loan. They then calculate what the new interest rate would be if the buyer were paying for the loan fees over the life of the loan along with the regular interest that they will also be paying.
There is a two-step process to finding the APR. (1) Add the total fees into the original price of the house. Then use the interest rate to calculate what the new monthly payment would be. (2) Use the amount you just calculated to work backwards to determine what the rate on the APR would be.
The APR will always be higher than the standard interest rate because it is including the total fees, such as prepaid insurance and interest, along with closing fees.
Does the APR Matter?
The APR is a good indicator of which loan is giving you the better deal over the life of the entire loan. If you plan on staying in the house until you have paid off the loan, the APR will do the proper job of showing you which loan is better. However, if you are only in the house for a short time you may be better off to go with the loan that has the higher APR.
While it is important to understand the interest rate and APR, it is also important to understand what your long-term goals are. Knowing your plans helps you know whether the APR will matter to you.
It also help you calculate at what point the APR will come into play based on the length of time you are in the house. Just like everything in the home buying process, the more knowledge you have, the better decision you can make.