APR vs. interest rate for mortgages

APR and interest rate are both important numbers when choosing a mortgage loan. But which matters more?

Some experts say APR is most important because it includes your interest rate your loan fees. It’s the ‘real’ cost of a mortgage.

But APR is often too broad to be a good comparison tool.

Today’s mortgage shoppers have a lot of flexibility to choose their interest rates and upfront fees. So you should choose the combination of short- and long-term costs that makes sense for you — rather than looking for the lowest APR or interest rate alone.

In this article (Skip to…)

• What is APR?
• How is APR calculated?
• Difference between APR and interest rate
• APR vs. interest rate for mortgages
• When to use APR vs. interest rate
• Fixed- versus adjustable-rate loans
• How to find the best mortgage deal

APR can be found on the Loan Estimate you’ll get from any lender after being pre-approved. It is provided to enable borrowers to make a more informed decision when it comes to loan choices.

“By law, the APR must include interest, points, loan origination fee, broker fee, and mortgage insurance,” says Scott Auen, senior vice president of Retail Lending for Cornerstone Bank.

“There are also third-party fees that legally cannot be included, such as notary, home appraisal, and attorney costs. And there are other fees that some lenders include while others don’t.”

This means APR is not a perfect way to compare mortgage loans apples-to-apples. You have to look at the interest rate and total upfront fees, too.

For example, the interest rate quoted for an FHA mortgage could appear enticingly low. Advertised rates for FHA loans are typically below rates for a comparable conventional loan.

But because an FHA loan requires annual mortgage insurance — which costs 0.85% of the loan amount each year — its APR will often be higher than a conventional loan.

APR is often a better tool for comparing multiple loan products: For instance, an FHA loan vs. a conventional loan.

Factors like your credit score and down payment also make a difference when it comes to loan fees and APR.

“APR is often a better tool for comparing multiple loan products,” says Nishank Khanna, chief financial officer for Clarify Capital.

“If you have a low interest rate loan but tons of fees, calculating APR costs can help you better understand how much you’ll really be saving or spending.

“APR is a more complete metric for comparing mortgages with different interest rates and total fees. It levels out the playing field, allowing you to see things from an apples-to-apples perspective,” Khanna continues.

Drawbacks of using APR to compare loans

For many borrowers, though, APR is not a realistic way to compare costs.

That’s because the APR calculation makes a few big assumptions:

• APR assumes you’ll keep your loan for its full term
• APR assumes you won’t sell the home or refinance
• APR assumes you won’t pay off the loan early

Most borrowers do not pay off their mortgage in full. It’s typical to sell or refinance after only a few years. So comparing loans based on their long term cost might not make sense.

And APR doesn’t account for different financial priorities.

For example, some borrowers choose to pay discount points. Points can add thousands to your upfront fees but significantly reduce your interest rate.

“In this case, having lower mortgage payments or building equity is a priority. Hence, it might be wiser to put more stock in the interest rate number than the APR number,” Khanna suggests.

On the flip side, some borrowers want or need to save money at closing.

They might accept a lender with a higher interest rate and APR if it’s willing to cover part of their upfront costs.

“In this scenario, having a higher interest rate loan with fewer upfront fees can be more affordable month-two-month,” says Khanna.

“Borrowers should consider how much liquid assets they have and what they are comfortable with paying at the get-go rather than simply pursuing a loan with the lowest APR.”

The 5-year cost projection can be found on page 3 of your Loan Estimate, directly above the APR. It shows the real cost of your loan after 5 years, including loan principal, interest, and upfront costs.

This number will be more realistic for a short-term borrower than APR, which spreads loan costs over the full loan term — often 30 years.

If you’re comparing ARM interest rates, you may notice something odd: the APR can actually be than the interest rate.

This isn’t because ARMs have low or no loan fees. Rather, it’s because of the way lenders calculate APR on an adjustable-rate loan.

The annual percentage rate on an ARM is based on the index rate your loan is tied to. An index is simply a measurement of the economic conditions at the time, expressed in an interest rate.

But ARM APRs assume the index rate will stay the same over the life of the loan. Not likely.

For instance, say you take out a 5/1 ARM. Your initial interest rate is 3.5%, and your ‘margin’ is 2.25%. On the day your loan closes, the index rate your loan’s tied to is at 0.5%.

• Initial interest rate: 3.5%
• Index rate at closing: 0.5%
• Your loan’s margin: 2.25%
• APR: 2.75%

This calculation can make ARMs look incredibly attractive during a low-rate period like the one we’re currently in — especially if you’re shopping based on APR.

But this calculation makes the assumption your interest rate will fall when the loan finally adjusts. If you take the ARM out when rates are at rock bottom, this is unlikely to happen. It’s more likely your interest rate and monthly mortgage payment will increase.

So, don’t be fooled by the ultra-low APR on an adjustable-rate mortgage. It’s an estimate based on some big assumptions

And many borrowers sell or refinance before their ARM’s fixed-rate period is up, in any case.

Verify your new rate (Feb 9th, 2021)