APR stands for annual percentage rate. The term refers to the actual effective cost of borrowing money, factoring in both the interest rate (the amount you pay annually to borrow the money) as well as any other costs. While most homeowners can tell you their mortgage interest rate, they surprisingly stumble when asked what is the APR on their mortgage. Unfortunately APR is a much better measure of what you actually will pay for a mortgage since different loans have different terms and fees associated with them.
The APR takes into account all of the costs of borrowing money to give you an idea of what you actually pay for the privilege of borrowing. The Truth in lending Act requires that mortgage lenders provide details on their APR to borrowers whenever they advertise their interest rates so that you can make a more informed choice.
The APR takes a number of different things into account including:
- Points you pay. Discount points are money that you put down in order to lower your interest rate. The cost of buying one point is equal to one percent of the mortgage amount so, for instance, if you were borrowing $100,000, one point would cost $1,000. Each point you buy lowers your interest rate on the money borrowed.
- PMI. If you put down less than 20 percent of the home, you will have to pay for mortgage insurance to protect the lender. Your APR factors in the costs of paying PMI.
- Pre-paid interest. Interest is normally charged monthly on a mortgage loan. Pre-paid interest is thus required when you close on a mortgage to cover the time between the closing date and the first date of the next month when interest begins to accrue for that month.
- Origination costs and fees. This is money paid to the lender for the work they do in getting you the loan.
These fees and costs can be quite expensive in many cases, sometimes totaling in the thousands of dollars. When one loan has many more fees and costs than another, it can actually be a worse deal for you than a loan that has a higher stated interest rate.
Comparing the APR, therefore, is the only way to truly compare different loans among different lenders in order to decide which one is the best deal in the end. A loan that advertises a 3 percent interest rate, for example, might require you to pay several points to get that rate and may thus have a higher APR even though the interest cost is lower.
Be a smart mortgage shopper. Understanding what is APR will help you as you shop for mortgages to make you are aware of the full cost of the mortgage in addition to interest cost.