That may be easier said than done, because in addition to your quoted mortgage interest rate, lenders are also required by law to provide an annual percentage rate (APR) as part of your quote.
These two numbers are related but not always equal.
The APR builds in all the fees your lender plans to charge on your mortgage to create what’s known as an effective interest rate. So the APR is almost always higher than your quoted interest rate.
While this practice is useful on short-term debt like credit cards or car loans, money expert Clark Howard is leery of putting much stock in an APR for a mortgage because of the term of the loan.
"Completely ignore APR when it comes to a mortgage," Clark says.
In this article, I’ll into the differences between the two numbers, why your lender quotes an APR in the first place — and why Clark says it’s best to ignore APR when it comes to mortgages.
Interest Rate vs. APR: What’s the Difference?
The quick answer is that an interest rate is the “advertised” rate that you’ll get as a part of a quote, while the APR takes that rate and adds the cost of associated fees into the equation to give you an “effective interest rate” over the full term of the loan.
The interest rate refers to a percentage of the amount of money that a lender will charge you for access to the money required to make your purchase. In the case of a mortgage, it's usually charged over a 15 or 30-year term.
A number of factors determine this rate including the Federal Reserve’s rate for lending money to banks, your credit score and the amount of money that you’re looking to borrow in relation to the appraised value of the property.
The APR was developed as an effort to give borrowers a more complete picture of the costs of credit instruments. In addition to the amount of interest owed on the loan, the APR also includes upfront expenses and fees, such as closing costs and mortgage points, into the equation to give you an effective interest rate.
Lenders are required to disclose the APR on mortgage loans as a consumer protection provided under the United States' Truth in Lending Act.
How Is the APR on a Mortgage Calculated?
If you know only the interest rate for a mortgage quote and want to measure it against an APR quote so you can get a true apples-to-apples comparison, you can calculate the APR on your own.
In fact, the formula is not overly complicated. Here’s how it works:
- Total up all of the fees for the loan.
- Add the loan fees to the total loan amount.
- Using the loan's interest rate, calculate a new monthly payment as if the loan fees were a part of the borrowed principal.
- Take this mythical monthly payment, which should be higher now that fees are included, and convert the payment into a new interest rate. (A financial calculator may be required for this, though you could reverse engineer it on a standard mortgage calculator.)
If you're looking for a shortcut, you could use an online mortgage APR calculator like this one from NerdWallet.
What if the Rate and the APR Are the Same?
This should happen only if the quote you're getting is for a no closing cost loan.
If you are being offered a loan that has upfront fees, the APR should reflect a higher number than the raw interest rate. If it doesn’t, it’s possible that you’ve been misquoted or that the lender is engaging in some unethical practices. You should ask about the lack of a discrepancy in those two numbers before moving forward in the loan application process.
Why Clark Howard Cautions Against Using APR for Mortgage Evaluation
While mortgage lenders are required to include an APR in your mortgage quote, Clark believes you’re under no obligation to consider it as part of your decision-making process.
"APR was designed forever ago to be an enormous consumer benefit. It would be this mathematical formula where a consumer could look at just one number and figure out what was the best deal for you. It never worked," Clark says.
"In fact, APR has turned out to just be gibberish for anything other than a simple interest loan like a credit card or a car loan. For mortgages, it has been a big, fat failure. It gives the consumer nothing they can make a decision with because the calculations that go into it when you take a 15- or 30-year mortgage and then they jumble all of the fees together and come up with an APR. It is useless. That's why people have to do more work instead of just a simple number that they're supposed to look at. You've got to look at your breakeven point and many of the other factors involved with a mortgage. APR is non-functional with a mortgage."
Clarks says one of the main reasons he feels APR is useless is that it factors the fees into an adjusted interest rate that applies to the full term of the loan, when in reality most people either sell a home or refinance a loan before the term is complete.
"Historically, the average person keeps a home for just under seven years," Clark says.
"So when you do a calculation based on the 30-year amortization schedule, the result is that it makes a loan with higher fees look like it would be a lower cost than it typically would be for a consumer."
Instead of focusing on APR, Clark suggests comparing interest rates and their associated fees through the lens of a breakeven point on your upfront costs via interest savings.
Tools to Help: Refinance Breakeven Calculator and Mortgage Points Calculator
Since Clark believes that looking at the APR is bad way to determine your best deal for a mortgage, Team Clark has some tools that can help you with your calculations.
If you're refinancing, we have a breakeven calculator that lets you plug in the terms and fees for your quotes and determine which is better based on how quickly you can recoup the cost of upfront fees via interest savings on your monthly mortgage payment.
If you're trying to decide between a loan quote with points versus one without points, we have a mortgage points calculator that will help you find the amount of time that you'll need to recoup the upfront fees you may pay to lower the interest rate.
Final Thought
Taking out a mortgage for your home is one of the most significant financial decisions you will make. So having a clear understanding of the information that is being presented to you is of the utmost importance.
The most important step for evaluating multiple home loan quotes is to ensure you’re making an apples-to-apples comparison on the interest rates. If you’re going to use APR, make sure all of the rates you’re comparing it to also are APR. The same holds true if you choose to eliminate APR from the equation.
But Clark doesn’t think you should spend much time or energy on APR comparisons.
He’d much rather you gather information on the raw rates and fees and then calculate a breakeven point for recouping those fees through interest savings. From there, you can properly evaluate which loan is best for you based how long you stay in your home or keep the same loan.
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