What Is The Difference Between APR & Interest Rate When Buying A Home?
When shopping around for a mortgage, most people think that finding the lowest interest rate is the best way to secure a good deal. While the interest rate is an important factor to consider when deciding whether your loan is affordable, it doesn’t give you the full financial picture of your borrowing cost.
What Does Interest Rate Tell Us?
The Interest Rate is the percentage which the lender charges on the outstanding balance of the loan. Put simply; it is the cost you will incur for borrowing the money to fund the purchase of your home.
Knowing your Interest Rate allows you to calculate how much of your monthly mortgage payment will pay your principal, and how much of it will go toward paying your interest.
For example, when calculating the interest payment on a home loan of $300,000 with an annual interest rate of 5%, you would multiply the interest rate by the remaining balance of the loan.
Outstanding Loan Balance $300,000
Annual Interest Rate 5%
$15,000 interest charge for the first year
The problem with relying solely on the interest rate to predict home loan costs is that it does not take into account other fees that lenders may include when you buy a home, such as loan origination costs or any mortgage points purchased.
To truly get an accurate idea of the cost of your home loan over its duration, it is essential to know what your APR is.
What Does The APR (Annual Percentage Rate) Tell Us?
The APR of a loan is an annual rate that encompasses all associated costs of the loan and combines them into a percentage value. For example, the APR includes the interest rate charged by the lender, as well as other costs such as mortgage insurance and closing costs.
Using the APR to calculate the cost of borrowing is a more accurate way to decide the affordability of a mortgage when buying a home. The APR is meant to be a transparent way for consumers to calculate the total cost of borrowing. It is so essential, in fact, that disclosure of the APR is governed by the Truth in Lending Act (TILA), which states that all loan costs must be made clear to consumers on all Closing Disclosure Documents and Official Loan Estimates.
As the APR includes all of the costs of borrowing, it is typically higher than the interest rate. The APR can also, like the Interest Rate, vary from borrower to borrower, and is dependent on your credit history and the particulars of the mortgage you are applying for, amongst other things.
For example, if the bank believes you are a ‘low risk’ borrower, and unlikely to have trouble repaying your loan, your APR will reflect this and will, therefore, be a lower percentage.
APR can also rise if you decide to purchase mortgage discount points. Many lenders offer discount points, which give the borrower a way of ‘buying down’ their interest rate.
If you would like to estimate the APR of your loan, The United States Treasury Department provides a free service named ’ARPWIN’ which uses the interest rate, the amount borrowed and the length of the loan term, to calculate the actuarial APR.