Introduction

When it comes to getting a mortgage, most prospective homebuyers focus primarily on the interest rate. While the interest rate is a major factor, it does not tell the whole story of the cost of borrowing. Another important metric to consider is the Annual Percentage Rate or APR. Although the APR does not consider the entire cost of borrowing to buy a home, it does offer valuable insights into the cost of getting a loan. The APR is one of the tools that you can use to compare lenders and is a great way to compare different loan products with the same lender. In this article, we will look at the differences between your interest rate on a mortgage and the APR.

Understanding Mortgage Rates

The interest rate on a mortgage is the percentage of interest that lenders charge borrowers for a home loan. Your monthly interest cost is calculated by multiplying the interest rate by the current balance of your mortgage loan. The interest rate directly affects the monthly mortgage payment with a lower rate giving you a lower monthly payment and a higher rate leading to a higher monthly payment. Mortgage rates are influenced by various economic factors, including inflation, the Federal Reserve’s monetary policy, and market conditions.

For borrowers, getting a lower mortgage rate is generally seen as a positive outcome, because it directly reduces your monthly payment and the amount of interest paid over the life of the loan. Homebuyers often shop around for the best rates, comparing offers from different lenders to find the most favorable terms. However, focusing solely on the interest rate can be a mistake, as it does not provide a complete picture of all borrowing costs.

The Role of APR

While the mortgage rate represents the cost of borrowing in terms of interest, the Annual Percentage Rate (APR) takes a more comprehensive approach. APR includes not only the interest rate, but also other fees and costs associated with the loan, providing a more accurate representation of the total cost of borrowing over the loan term. The APR includes other monthly costs in addition to interest such as the cost of monthly private mortgage insurance (PMI) as well as the cost of upfront mortgage insurance. The APR also includes the upfront cost of getting the mortgage such as loan origination fees and other closing costs. Most importantly, the APR includes the cost of points which are a direct way for borrowers to pay money upfront to buy a lower rate over time.

The difference between an interest rate for a mortgage and the APR is that the interest rate is expressed as a simple percentage of the loan amount, while APR is presented as a yearly percentage that includes the interest rate and associated costs. The APR is typically higher than the mortgage rate due to the inclusion of fees and other expenses. The key takeaway is that a low interest rate does not necessarily mean a low APR. Lenders might compensate for a lower interest rate by charging higher fees, leading to a higher APR. Conversely, a higher interest rate might be accompanied by lower fees, resulting in a relatively lower APR.

What is in the APR

The APR includes several monthly and upfront costs which make it a valuable tool to understand your true cost of borrowing. However, the APR can be misleading because the lender does not have control over a number of the costs that are included in the APR. If the lender is not directly responsible for the cost, then the lender is only providing an estimate of the cost. If you are trying to compare lenders using the APR, you may end up picking a lender based on their estimated costs and those cost estimates may be manipulated by a lender who is trying to win your business.

And now here is a list of the costs that are INCLUDED in the APR:

1. Origination Fees: This is a fee that the lender charges for underwriting and processing the loan. Although it is sometimes a percentage of the loan amount, it is usually a flat fee between $1,000 and $2,000 (Get more information on Origination Fees). The lender controls this fee, and it should be used to compare lenders to one another.
   
   
2. Points: Points are an upfront fee that is used directly to buy a lower rate. A point is equal to 1% and half a point is equal to 0.50%. For example, on a $300,000 loan you can pay one point (1.00% of the loan balance or $3,000) to drop your rate by 0.375% and save $72 on your monthly payment. In this instance, your breakeven on paying the points is 42 months or about 3.5 years. If you do not sell the property or refinance the mortgage before 3.5 years, then it made some sense to buy the points. If you sell or refi prior to 3.5 years, then you wasted your money. If it seems that you are not getting a lot of savings for buying the points, this is probably true, particularly if you hope to refinance in the future (Get more information on Points). Paying points will always cause the APR to go up. When the lender is quoting you a rate for the first time, make sure that you get a quote with zero points so that you a clear picture of your cost before paying points.
   
   
3. Broker Fees: Compensation for mortgage brokers that is expressed as a percentage of the loan amount. Since the financial crisis in 2008-2009, most loan originators are bankers or mortgage companies who originate and fund the loan in their own name and then sell the loan to an investor after the closing. For this reason, it is extremely rare to pay broker fees when you are getting a mortgage. Make sure that you ask your lender if they are acting as a broker or not, and then find out if there is a broker fee.
   
   
4. Mortgage Insurance: If you have less than 20% down payment and you are getting a conventional loan, then you will most likely be paying monthly mortgage insurance as part of your monthly payment (Get more information on Mortgage Insurance). In most cases, you will pay the same interest rate whether you have 5%, 10% or 20% down payment. As your down payment increases, your mortgage insurance will decrease until there is no mortgage insurance if you have 20% down payment. Because mortgage insurance is included in your APR, a loan with 5% down payment will have a higher APR than a 10% down payment loan if the interest rates are the same. If you are comparing two down payment options presented by your lender, it would make sense to compare the APR of both options. Because the lender will find a mortgage insurance provider on your behalf, you can use the APR to compare different lenders. Because the cost of mortgage insurance is important to you, Lakeside Bank will shop for mortgage insurance on your to at least a half dozen different mortgage insurance carriers to make sure that you get the best deal.
   
   
5. Title Costs: These are costs associated with making sure that your ownership of the property is free from any restrictions (Get more information on Title). The role of title costs in calculating APR is confusing at best. Certain title fees are added to the APR such as the escrow or closing fee and any miscellaneous fees charged by the title company for services such as email, couriers, wires and recording. However, the costs of title insurance itself and the endorsements that it includes are typically excluded from the APR.  Because title costs are both included in and excluded from the APR, it is hard for a borrower to figure out how these expenses impact their cost. To make things more difficult to understand, the lender may not have any role in picking the title company and therefore has no influence on the fees charged. For example, in the State of Illinois the seller’s attorney typically picks the title company and the lender is not involved in determining the fees. In other states, the realtor picks the buyer’s title company, and the lender has no role.  If the lender does not control the title costs, then the lender is using an estimate of the title fees in the APR. A thoughtful and ethical lender may show higher title fees in their estimate so that you are not surprised when the costs are finalized at the closing. Unfortunately, there are some lenders who will show you lower title fees in their estimate so that their costs seem lower, and they win your business. When it comes to title costs, the APR is neither a useful gauge of your cost of borrowing nor a good way compare lenders.
   
   
6. Condo Questionnaire: When you are buying a condo, the lender needs to not only underwrite you but also the financial health of the condo building. To do this, the lender asks the property manager or condo Board to complete a condo questionnaire. The lender typically purchases the condo questionnaire on your behalf, and you reimburse the lender. Because the property manager or homeowners’ association determines the fee for the condo questionnaire, the lender has no say in what costs and can only provide you an estimate. As we mentioned above, an unethical lender may show you a lower fee just to win your business. For this reason, the APR may not be the best way to determine the total cost of your loan.

Fees Excluded from the APR

Now that we have looked at the costs included in the APR, we should look at some of the costs that are excluded. The APR excludes a few costs that are directly related to the cost of your mortgage even though these expenses are controlled by the lender. If you rely only on the APR to make a pick a lender, you may be paying more for certain mortgage fees even though you thought you were picking the lender with the lowest costs. The best plan is to look at the APR in addition to the fees and other charges that the lender controls.

And now here is a list of the costs that are EXCLUDED from the APR:

1. Appraisal Fees: Of all the fees that are excluded from the APR, this one makes the least sense. For almost any mortgage, you will need to buy an appraisal to make sure that there is enough collateral to support he loan (Get more information on your Appraisal). Although the lender orders the appraisal, you will pay for it upfront. Because the lender orders the appraisal, they control the cost of it. With an appraisal costing anywhere from $500 to almost $700 depending on the property, the appraisal cost can have a real impact on the APR. Because the APR does not include the appraisal, it does not really account for all your upfront costs.
   
   
2. Credit Reports: It is nearly impossible to get a mortgage without having your credit pulled and paying for the credit report at the closing (Get more information on Credit Scores). The lender uses a third-party vendor to pull your credit and has complete control over the cost of your credit report. It is a mystery why these fees are not included in the APR. The fees are not large to get your credit report run, so there is not a huge impact on the APR. It is still strange they are not in the APR.
   
   
3. Lender Credits: Quite often a lender may not be able to reduce your fees, but they are able to give you a lender credit at closing to reduce your closing costs. The lender credit offsets your closing costs and allows you to bring less money to the closing. The loan originator is often able to give you a lender credit by digging into their profit margins to win your business. For example, the loan origination fee for a lender might be $1,495 but they are able to give you a lender credit of $495 to effectively reduce that fee to $1,000. Although the lender credit decreases your upfront costs, it does not lower your APR. Using the example above, a lender with a loan origination fee of $1,200 would have a lower APR than the lender who has a $1,495 lender origination fee with a $495 lender credit (all other terms being equal). This makes no sense at all! If there is a lender credit for your mortgage, APR is not a good way to compare lenders or understand your cost of borrowing.
   
   
4. Other Costs Excluded: There are several other costs that are excluded from the APR because you must pay them whether you have a loan or not. You do not need these costs in the APR to compare lenders because they are all estimates. Once again, please do not pick a lender based on costs that the lender is estimating. A good lender will give you conservative and reasonable estimates for these items and an unethical lender will give you aggressive estimates hoping to use this technique to win your business.
   1. Homeowners Insurance: This is the cost of getting insurance to replace your property in case of a catastrophe. The lender estimates this cost, and knowledgeable lender will have a good idea about the cost of homeowners insurance in their geographic area.
   2. Escrow Deposits: This is not really a cost because funds are being put aside as savings to pay your property tax and/or homeowners insurance bills in the future. Although it is not a fee, the size of escrow deposits may impact how much cash that you need to buy the home (Get more information on Escrows).
   3. Recording Fees: This is the cost of recording your mortgage and deed at the county. It is a predetermined cost and easy to calculate.
   4. Transfer Taxes: This is a one-time tax that you pay to the City, State or County for buying a property. Although most transfer taxes are paid by the sellers, there are certain communities where you will have to pay it and it can be significant. For example, if you are buying a property in the City of Chicago for $400,000, you will have to pay a transfer tax of $3,000 at closing. Make sure that you are working with knowledgeable lender who know the transfer tax rules in your community.
   5. Attorney Fees: It is not customary in all jurisdictions to hire an attorney to represent you in a real estate transaction. If you are buying a property where the seller is typically represented by an attorney, it is important that you have your own lawyer. If you hire a knowledgeable lender, they can get you an accurate estimate of the cost of an attorney and refer you to a good one!

Conclusion

By factoring in upfront costs, APR offers a better assessment of the true cost of borrowing than just looking at the interest rate. It helps borrowers compare loan offers from different lenders on an apples-to-apples basis, considering both the interest rate and the associated fees. But the APR is not a perfect measurement of the cost of getting a mortgage. To compare lenders, you really need to look at the interest rate, APR and then also compare the costs that the lender controls. In most cases, you can compare lenders by looking at the following numbers:

• Interest rate
• APR
• Points
• Loan origination fees
• Appraisal costs
• Other minor fees (credit reports, tax service fees, flood, etc.)
• Lender credits that the lender is offering to decrease the costs listed above

By looking at these numbers side by side for each lender, you can get a good idea of who is providing the lowest cost. It takes a bit more work this way, but you will feel better having done your due diligence.

In addition to comparing the costs above on each lender, you should also look at the overall cost of the financing by getting fee sheets or loan estimates from each lender. Watch out for lenders who are trying to win your business by undercutting fees on their sheets or leaving off certain fees. A lender who gives you a fair and reasonable picture of the total costs and the cash needed to close the mortgage will end up costing you less at the closing. And that is all that matters.

To make sure that you are “getting a great deal”, you should also make sure that you are working with a lender who is willing to show you all the costs and is happy to explain them to you in detail. If you do not pick a lender who is honest and transparent, it does not matter what they show you on paper. An unethical lender will always charge you more in the end! Finally, I highly recommend that you look at more than cost when picking a lender. Try to consider not only cost but the way the lender tries to explain costs and how the mortgage process works. Try to get a referral from your family, a friend, or your realtor for a lender that you can trust. Check out the lender’s online testimonials (mine are listed below) to see what other people are saying about their expertise, communication skills, transparency, and honesty. You do “get what you pay for” and picking a lender only based on cost will get you in the end. In addition to the rate, your lender is responsible for guiding the mortgage process, explaining to you how it works and fixing things when they go wrong. Nothing is more expensive than a messed up mortgage execution that is run by a mortgage lender who is only qualified to quote rates.

Check out our Reviews on Google and Yelp!

Google (115+ reviews) | Yelp (185+ reviews)