What Is Annual Percentage Rate and Why Is It Important To Borrowers?
Shopping for a loan can be a daunting part of the home buying process since it can dramatically impact how much borrowers will end up paying for the property they are purchasing. When comparing different loan options, borrowers should consider several factors, but most importantly what interest rate and Annual percentage rate (APR) each lender is offering. Lending institutions are required by the Truth In Lending Act to disclose both these elements to borrowers.
Although they are both expressed as a percentage, interest rate and APR are different. The interest rate is the cost of borrowing money on the principal and can be fixed or variable. APRs, on the other hand, include not only the interest rate, but also all the additional costs associated with borrowing the money such as broker fees, mortgage insurance, closing costs, rebates, and discount points which is why they are usually higher (often between 0.15% and 0.25%) than simple interest rates. APRs do not take into account compounding. To simplify, APRs represent how much it will actually cost you to borrow money.
When comparing different loans, a good rule of thumb is to choose the loan with the lowest interest rate and APR. However, it is possible for two loans to have the same interest rate and fees, but different APRs depending on what charges the lender includes in the calculation so be sure to ask your lending institution which costs are included. Since the APRs are also calculated differently depending on the type of loan, it is preferable to compare similar products only.
However, in practice, APRs are not to enough to determine whether or not a loan is the right fit for you. The major downside is that the annual percentage rate is calculated assuming that the upfront fees will be paid over the life of the mortgage (usually 30 years), like the interest. The result is that the APR tends to understate the cost of the loan. If you are planning to keep the same mortgage for a long time, it is not an issue. On the other hand, if you are planning to sell your home or refinance before the end of the loan, you may end up paying more than you need to. If you do not intend to keep the property for decades, it may make more financial sense to pay fewer upfront fees and get a higher rate — and a higher APR — since the total cost will be lower for a short period of time.
If you intend for the house you are purchasing to be your forever home, or if you are considering refinancing in the future, it is worth pulling out your calculators or asking advice from an expert to determine what the break-even point would be between different loans.
Besides, when it comes to adjustable-rate mortgages, APRs base their calculation off a constant rate of interest since the future interest rate on an ARM is uncertain. In consequence, the APR presented by the lender could be way off if the interest rates were to increase significantly in the future.
Although APRs are an essential element to consider for potential borrowers, you will also need to pay close attention to the interest rate and the lender’s breakdown of loan fees to determine the best loan for you.