Understanding interest rates and APR

The terminology behind various financial products can be confusing at times, especially when it's your first time shopping for a home loan.

The terminology behind various financial products can be confusing at times, especially when it's your first time shopping for a home loan.

 

Anyone who is beginning the process of applying for a mortgage has probably already had to immerse themselves in a litany of definitions. The terminology behind various financial products can be confusing at times, especially when it's your first time shopping for a home loan. One of the most common sources of confusion in this process surrounds a loan's interest rate and the annual percentage rate.

Interest rate vs. APR

Any kind of loan, whether for a car or funds for a credit card, likely comes with an interest rate. For the service of providing you with the capital to make a major purchase like a home, a lender needs some compensation that comes in a few forms, one of them being the interest rate. This means that as a homeowner pays back the loan, they will be repaying not only the amount they used to buy it (the principle) but also the interest, which is a percentage of the principle that's added on for as long as the loan's balance is outstanding. That's why the longer it takes to pay off a loan, the more it usually costs.

Lenders will often quote their daily interest rates in marketing materials, but may also include another number, the APR, alongside it. As Realtor.com explained, the APR reflects the net additional cost of the principle after the interest rate and all other fees are factored in. There are a number of additional costs other than interest that may be built into the APR, including:

  • Discount points: An additional fee paid upfront in exchange for a lower interest rate
  • Origination fees: A charge for the cost of creating a loan, which includes research on the borrower's credit history and financial background
  • Mortgage insurance: Additional charges that may be tacked onto a loan if the borrower's down payment is less than 20 percent of the loan's principle value
  • Prepaid interest: Interest charges covering the amount of the loan between the date of closing and the first mortgage payment

The advertised APR may not differ significantly from the offered interest rate, but the fees bundled up within could amount to significant additional costs. At the same time, other expenses generally considered "closing costs" are not usually included in the APR. These may include fees for appraisals, title insurance and the home inspection.

APRUnderstand what's included in your interest rate and APR before signing up for a mortgage.

Comparing carefully

Carefully analyzing the fine print behind advertised interest rates and the APR on a loan could allow a borrower to make a more informed decision on whether or not to sign up. Lenders tend to promote a low APR on loans that require high upfront fees. If a borrower chooses one of these mortgages, they may save in the long run, but could end up losing money if they end up selling the home quickly.

To avoid this mistake, shop around for the best deal on a mortgage and pay attention to all fees included in the APR as well as closing costs. At the same time, consider the structure of the loan and whether it fits your needs. If you feel certain that you'll be staying in your new home for a long time, it might be worthwhile to pay more upfront in exchange for lower costs over the long term. On the other hand, paying less at first and spreading costs out may be beneficial when moving in the near future is a possibility.

In any case, work with your lender and do your homework to get the best possible deal on a mortgage.