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Mortgages Part 3: Interest Rate vs APR

Interest Rate vs APR

Last week we continued our discussion on mortgages when we went over PITI. When all the posts in the series are complete, you should have an understanding of mortgage types, structure, rates, points, fees, mortgage insurance, and refinancing. This week let’s discuss two common interest terms that often get confused, interest rate vs APR (annual percentage rate).

Interest Rate vs APR

So far, when we’ve used interest, we’ve been talking about RATE. You may remember that interest was defined as how much a lender charges to loan you money. This is true of both Interest Rate and APR. However, the costs being measured by each is different.

Interest Rate

Interest Rate calculates what your monthly payment is going to be. Typically, the interest rate is calculated monthly. At the end of the month, your remaining principal is used to decide how much interest you still owe. Therefore, as you lower your principal owed, you lower your interest owed as well.

If your primary concern is getting the lowest monthly payment rather than the total cost, then this is for you. Let’s say you are someone who is buying a home for 5 years or so. Maybe you know you’ll be transferred for work.  Perhaps you are planning on having kids.  You know you’ll be moving within a few years. In this case, you may want to accept a higher rate with fewer upfront points (we’ll go over points next week) and fees to reduce the cost of the loan over that time.  (Refer to the comparison chart using figures provided by Bankrate)

$200,000 mortgage with different rates and APRs
Interest rate 4.5% 4.25% 4%
Discount points 0 1.5 3
Points and fees $2,800 $5,800 $8,800
APR 4.619% 4.492% 4.36%
Monthly payment $1,013 $984 $955
All costs, 3 years $39,281 $41,220 $43,174
All costs, 10 years $124,404 $123,866 $123,380
All costs, 30 years $367,613 $354,197 $343,739

Annual Percentage Rate (APR)

APR calculates what the total cost of the loan is. Interest Rate only considers principal when calculating what’s owed. APR takes into consideration origination fee, discount and mortgage points, mortgage insurance, and prepaid interest to name a few. Other closing costs such as title, recording fees, appraisal, inspections, and home insurance are not included. I know it’s confusing that there are insurances both included and not included.  We will go over the differences between the two in a later post.

APR’s primary purpose is to keep the banks honest on how much a loan costs. They used to be able to say that you are getting a low rate to hook you into the loan. Then they put in a bunch of fees and charges on top of the cost of the home, wrap it into the mortgage, and charge you interest on fees they added. So if they gave you a 4% loan for 30 years and put a $1,000 fee in there, you ended up paying three thousand over time. By including these costs and dividing it over time as a percentage of the loan, you get a better idea on how much a loan actually costs you when it’s finished.

Final Thoughts

Both rates are important and useful to look at. But as mentioned before, your time in the home changes which one matters most. APR works best when you plan on staying in the home for the life of the loan. Interest Rate works best when you are concerned about monthly payments. Even if your primary concern is lower payments, you can still use APR to figure out how much money you are going to spend over the life of the loan. It’s not uncommon for people to essentially buy their home twice once you consider how much interest you paid. If you buy a $300k home at 5% interest with 5% down, at the end of 30 years you will have paid $665k!

In a later post we will go over finding your break even time and points. These are things that will help build your ability to gauge if you are being ripped off or not when you can combine that with a basic understanding of your interest rate vs APR. Remember the chart? Depending on if you stay in a house for 3 years or 30, the total of your costs can actually go up with a lower interest rate. Inversely, the lower rate can dramatically lower total cost when you stay in the home for the life of the loan.

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