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What is the difference between a loan’s interest rate and the APR?

 

When you see both an interest rate and an Annual Percentage Rate (APR) for each mortgage loan many people become confused. The easy answer to “why” are both advertised is that the federal law requires the lender to tell you both.

 

The APR is a tool for comparing different loans, which will include different interest rates but also different fees, ipfront costs and other terms. The APR is designed to represent the “true cost of a loan” to the borrower, expressed in the form of a yearly rate. This way, lenders can’t “hide” fees and upfront costs behind low advertised rates.

 

While it’s designed to make it easier to compare loans, it’s sometimes confusing because the APR includes some, but not all, of the various fees and insurance premiums that accompany a mortgage. And since the federal law that requires lenders to disclose the APR does not clearly define what goes into the calculation, APRs can vary from lender to lender and loan to loan.

 

The APR on a loan tied to a market index, like a 5/1 ARM, assumes the market index will never change. But ARMs were invented because the market index changes and makes fixed rate loans cheaper or more expensive to make. Also, the costs are amortized over the term of the loan. If a borrower plans to keep the loan for a shorter period, the APR calculation would be inaccurate. The APR also does not reflect lender credits.

 

So, APRs are at best inexact. Although the APR comparison is a great tool when comparing traditionally structured mortgages, on more complex mortgage transactions, it is less effective. The lesson is that APR can be a guide, but you need a mortgage professional to help you find the truly best loan for you.