Lenders are required to give you an interest rate, along with an APR, or annual percentage rate, when they advertise mortgage rates. The APR is designed to make it easier to comparison shop for loans by giving you a means of comparing not only the interest rate you will pay, but also closing costs.
The annual percentage rate is the annual cost of the mortgage as a percentage of the loan amount. It considers not only the interest rate, but also points, mortgage insurance and lender charges. Third-party charges are not included. The APR will be higher than the interest rate, although the difference will depend on the lender and loan program.
Unfortunately, an APR can be misleading because there is no standardization in terms of what must be included in the APR. As you compare mortgage quotes, you will not necessarily know which fees each particular lender includes in the calculation. Title fees and appraisal fees are almost always excluded, however, as these are third-party fees that are not charged by the lender. While some settlement charges will not vary too much between lenders, closing costs can vary by thousands.
There is a second reason the APR can be misleading: it assumes that you will keep the loan for the full term. This means that if you get a 30-year loan, the APR you are quoted assumes that you will not sell the home, pay off the loan early, or refinance within the next 30 years. It will also not take into account inflation. Closing costs are thus amortized over the length of the loan.
If you are getting an adjustable-rate mortgage (ARM) instead of a fixed-rate loan, the APR will be practically meaningless as no one, not even the lender, knows what your rate will be when the loan resets.
Do not assume that the mortgage quote with the lowest APR is automatically the best deal – unless you plan to keep the mortgage for the length of the loan and never make any extra payments or refinance.
For example, assume you are getting a $100,000 30-year fixed mortgage with a 5 percent interest rate. One lender may charge $1,000 in closing costs, while the second charges $4,000. In the first example, the APR will be 5.09 percent, while the loan with the higher costs will be 5.35 percent. You may assume the first loan is the best deal, but if you sell the home five years later, the APR will have jumped to 5.41 percent.
While the annual percentage rate is a good tool to compare quotes, you cannot use it on its own. Always go over the Good Faith Estimate (GFE) you receive from the lender after applying for a loan, as this document will give you an estimate of the fees you will be charged, including those not in the APR.
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