Apr is higher than the interest rate

If you’re shopping for a mortgage, the annual percentage rate (APR) is a good way to compare our mortgage rates against other mortgage lenders.

Interest rate vs. APR – what’s the difference?

You’ll see these 2 terms when you start comparing mortgage rates. While both are expressed as percentages, they have some key differences.

You can lower your interest rate with mortgage points (discount points)

Discount points or mortgage points are a way you can lower your interest rate. They’re prepaid interest costs you or a seller can pay at closing to permanently lower the interest rate.

Here's how discount points work

One discount point costs 1% of your loan amount. While one point will typically reduce the interest rate by less than 1%, even a small interest rate reduction can lower your monthly payment and the amount of interest you pay over the life of a fixed-rate loan. Discount points may also be tax deductible (talk to a tax advisor for details).

Before buying discount points, consider:

• How much money you can pay upfront - make sure you have enough money to make a down payment, pay closing costs, and still be able to manage other expenses for your new home.
• How long you plan to stay in your new home - the longer you stay in your home, the more you may be able to benefit from buying discount points.
• How much can you pay each month - if you don’t have a lot of money to pay upfront and can handle a slightly larger monthly payment, you might be better off not buying points.

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A loan's Annual Percentage Rate, or APR, is the cost of your mortgage credit as a yearly rate.

Your Annual Percentage Rate is typically higher than your interest rate because it includes your interest rate plus certain fees, such as lender and mortgage broker fees, based on the specific characteristics of your loan.

The interest rate shows what percentage of your loan amount you will need to pay every year, over the life of your loan.

One type of fee often included in the APR is discount points.

Discount points are up-front charges paid to the lender voluntarily, usually by the borrower or seller, to reduce the interest rate. One point is equal to 1% of the principal amount of the mortgage.

Paying discount points can be advantageous if you have an extended loan term and you plan to stay in your new home for a while.

Applying for a loan isn't free. Another fee included in the APR is the amount the lender charges to process the loan application.

You'll hear this charge referred to as the "origination charge" and it includes any application, processing, and underwriting fees. These fees and charges vary. Typically the buyer pays the majority of the origination charge, but you can negotiate with the seller in your offer.

Lenders will approximate all the expected fees and charges in a disclosure document called the Loan Estimate, which estimates the total cost of the transaction.

As you can see, many variables can affect the cost of a loan, and it is important to look at not only the monthly amount you will pay, but the overall amount as well.

Annual percentage rate, or APR, reflects the true cost of borrowing. Mortgage APR includes the interest rate, points and fees charged by the lender. APR is higher than the interest rate because it encompasses all these loan costs.

Here’s a primer on the difference between APR and interest rate, and how to use it to evaluate mortgage offers.

Understanding these items is crucial when choosing the best mortgage lenders to work with. The interest rate is the percentage that the lender charges for lending you money. The APR reflects the interest rate plus the fees you paid directly to the lender or broker or both: origination charges, discount points and any other costs. Those fees add to the cost of the loan, and APR takes them into account. That's why APR is higher than the interest rate.

APR is a tool that lets you compare mortgage offers that have different combinations of interest rates, discount points and fees. Comparing APRs is most useful if you plan to keep the loan for more than six or seven years. But if you plan to keep the loan for less than six or seven years, APR comparisons could be misleading. That's because the APR calculation assumes that you'll keep the loan for its entire term. But not every borrower does that. Most people sell the home or refinance the loan before it's paid off.

As a hypothetical example, let's say you're comparing two offers on a $200,000 loan for 30 years:

• Loan A: You could borrow $200,000 with an interest rate of 4.25%, paying a 1% origination fee, no discount points and $1,000 in other fees. The 1% origination fee costs $2,000, and other fees are $1,000. Total fees: $3,000.

• Loan B: You could pay a discount point to reduce the interest rate. In this offer, you could borrow $200,000 with an interest rate of 4%, paying a 1% origination fee, 1 discount point and $1,000 in other fees. The 1% origination fee costs $2,000, the 1 discount point costs another $2,000, and other fees are $1,000. Total fees: $5,000.

Bottom line: Loan A has a higher interest rate (4.25%) and lower fees ($3,000), while Loan B has a lower interest rate (4%) and higher fees ($5,000), because you could pay $2,000 to buy 1 discount point to cut the interest rate by 0.25%. As you see in the table below, Loan B has a lower APR, which means that you end up paying less over the 30-year life of the loan when you include principal, interest and upfront fees.

How long you have the loan matters

The loan with the lower APR costs less over the mortgage's 30-year term. But what if you plan to keep the loan for less than that?

Loan A, without discount points, costs less in the first five years and eight months. Loan B, with discount points, costs less when you have the loan for five years and nine months or longer.

In this example, the break-even period for paying points is five years and nine months, meaning it will take that long to see the savings from paying those points. Not every loan has the same break-even period, which varies depending on the loan amount, interest rates and cost of fees and discount points.

APR is useful for comparison in some cases, but not all. Fortunately, there's another way to compare loan offers. It's in a section of the Loan Estimate that calculates how much the loan will cost in the first five years.

Using the Loan Estimate to compare mortgage offers

When you apply for a mortgage, the lender is required to give you a three-page document called a Loan Estimate. Page 3 of the Loan Estimate has a "Comparisons" section that lists not only the APR but also how much the loan will cost in the first five years: the loan costs, plus 60 months of principal, interest and any mortgage insurance.

In the earlier example, Loan A (4.38% APR) would cost $62,033 in the first five years, and Loan B (4.21% APR) would cost $62,290. So Loan A would cost $257 less in the first five years. Even though Loan A has a higher APR, it would be the better deal if you kept the loan for just five years.

When you get multiple loan offers, line up the "Comparisons" sections of the Loan Estimates side by side to help you decide.

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