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Interest Rate & APR: Cost vs True Cost

By Steve Matthews

Monday, June 1st, 2015

When applying for a mortgage, potential borrowers may consider two terms interchangeable: the interest rate and the annual percentage rate. They sound like the same thing but are, in fact, much different.

The interest rate reflects the base cost of borrowing money and is a percentage of the principal loan amount. For example, the interest rate for a 30-year, fixed-rate mortgage was 3.75% the week ending May 15. In this case, a borrower with a $250,000.00 mortgage would have a $1,157.79 monthly payment. (Payment is amortized using the loan amount and term, but doesn’t include escrow for property taxes or homeowners insurance.)

The annual percentage rate (APR) takes the base interest rate and adds in other costs for getting a loan, including underwriting fees, discount points (prepaid interest), per diem interest and private mortgage insurance. Because additional fees are factored in, the APR is typically a quarter to even half point higher than the interest rate.

The borrower’s monthly payment is still the same, but the higher APR rate reflects the true cost of a loan. This figure gives borrowers a way to compare lenders using both the interest rate and fee structure to see which loan is more expensive.

Not all costs of a mortgage are included in the APR calculation. Fees normally not included in the APR include charges for title insurance, notary, document preparation, home inspection, recording fees, transfer taxes, credit report and home appraisal.

APR doesn’t always tell the whole cost story. Borrowers should keep in mind that some lenders like Keegan may offer a credit to offset closing costs, and that isn’t determined until the rate is locked. The APR also spreads costs across the term of the loan. So the APR won’t reflect the true cost of a 30-year loan paid off in 20 years.

Here are a few more considerations.

• ARM headaches. The estimated APR can be misleading for an adjustable-rate mortgage (ARM), especially since the initial interest rates are very low. For example, the average interest rate for a five-year, adjustable-rate mortgage was 3% for the week ending May 15. But, hypothetically, if mortgage rates jump to 5% when the initial five-year loan term passes, a borrower will be stuck with significantly higher house payments. So APR for an adjustable-rate mortgage doesn’t suggest the risk involved.
• Other factors. While costs reflected in an APR are important, consumers should consider a variety of factors when comparing mortgages, including the term of the loan, size of monthly payments and their tolerance for risk. Borrowers can also reduce the lifetime cost of a loan by paying closing costs upfront instead of folding them into the loan.
• New form soon. Starting Aug. 1, lenders are required to use new forms created by the CFPB that aim to make it easier for borrowers to find and understand the terms of their loan. For those getting an adjustable-rate loan, the form provides the projected minimum and maximum payments over the life of the loan. The paperwork also breaks down closing costs and indicates which third-party services borrowers can shop around for. For example, many borrowers stick with a Realtor designated title insurance company, but rates can differ widely among providers.