How to Use APR to Your Advantage When Buying a House
You may be no Suze Orman, but you’re pretty smart when it comes to finances. You’ve managed your credit cards well, you have some savings, and you pretty much get how most financial stuff works, right? But even someone with borrowing experience can have a tough time explaining the difference interest rates and APR when shopping for a mortgage—let alone how that knowledge can help you get the best deal on your home purchase. Fortunately, a little know-how can clear up the confusion and help a house hunter determine their best financing deal. Here’s what you need to know.
Interest Rate vs. APR: What’s the Difference?
So here’s how it works: interest rate is a straight-forward percentage of how much you’re charged to borrow money. It will be used to determine your monthly mortgage payment. Let’s say you borrow $300,000 at a 4 percent interest rate over 30 years. Your principal and interest payment will be $1,432.25. (You can calculate your own numbers by using an online mortgage calculator.) But that’s not what your mortgage payment would actually be (surprise!). That’s where APR comes in.
See, in addition to the interest rate, lenders usually charge various fees for services related to the mortgage, like loan origination, processing and underwriting. Most borrowers don’t pay for these services up-front. Instead, they’re typically added on to the amount financed. And not all lenders charge the same fees, so they can vary widely. See how that $1,432.25 could start changing?
That’s why APR was created as part of the Truth in Lending Act. In a nutshell, APR is intended to give borrowers the ability to make an apples-to-apples comparison between different mortgage offers. It bundles the up-front lender mortgage fees with the interest rate, and a bunch of math later, you have your true cost over the term of the loan. So, basically, APR makes choosing the right mortgage for you way easier and more transparent, which is awesome.
What APR Can’t Do
Though undeniably helpful, APR does have some limitations that are important to keep in mind. For starters, it can’t be used to compare loans with different terms. The same closing cost and interest rate information will yield different APR numbers for a 15-year and a 30-year mortgage. Also, APR assumes you’ll remain in the home until the end of the loan term. If you move in seven years instead of in 30, your true APR will be higher than the number listed on your loan docs.
One last thing to know about APR is that if you have an adjustable rate mortgage (ARM), APR calculations are tough to do accurately. Because an ARM can adjust every year (after an initial fixed period), you have to make assumptions about future year interest rates when calculating APR, and it’s not like anyone uses a crystal ball to do so.
In the end, APR is more like Batman than Superman: not superhuman, but still likely to save the day. When you understand how it works, the APR calculation is the best tool a homebuyer can use to compare mortgage costs between lenders. When comparing, just be sure the loan terms are the same and the same fees are included within the calculation. With that info in hand, you’ll be sure to get the best mortgage deal possible.