When you are shopping around for a mortgage, car loan or any other type of credit, it is important to be able to compare the deals from one lender to another. Often, people will try to compare loan offerings among lenders by considering the interest rate that each lender is offering. However, because there are typically more costs associated with loans than just the amount of interest you pay, comparing loans by comparing their interests rate is not the most accurate way to do a comparison.
As a result, some financial experts suggest using APR instead. However, it is important to understand that APR isn’t always a foolproof comparison method either, especially if you use a stated APR quote and don’t take into account the specifics of your situation.
What is APR?
APR stands for annual percentage rate. It is a method of calculating and evaluating the total cost of a loan in terms of what percent of the loan balance you’ll pay for the privilege of borrowing money, much like an interest rate does. However, when properly calculated, an APR takes into account every cost of the loan including loan origination fees, private mortgage insurance, discount points, processing fees and any other annual fees.
For instance, assume that one lender was lending you $100,000 at a 7 percent interest rate with $1000 in closing costs and a $250 application fee and that the other lender was lending you $100,000 at a 7.5 percent interest rate but no closing costs or application fee. In order to do a fair comparison of these two loans and figure out which one was really the best offering, you would need to figure out the annual percentage rate or APR to determine the true cost of each loan.
In many cases, lenders give you an APR when you apply for a loan. In fact, according to Truth in Lending Laws, mortgage lenders are required to give you an APR in order to stop abusive lending practices where mortgage lenders quote a low interest rate to entice you to borrow but then dramatically raise the actual cost of the loan through fees.
Is APR a Good Way to Compare Lenders?
While an APR can be a better way to compare loans among different lenders, it is important to understand that even APR may not truly allow you an apples-to-apples comparison. While the APR should include most of the costs of the loan, some lenders may have fees and costs that are not required to be included. There are no set standards across lenders for how APR is calculated or what types of fees are included, and the APR is calculated with the assumption that you will keep your loan for the entire repayment term (i.e. for a 30 year mortgage it is assumed you will always keep the loan for 30 years).
An APR also does not include details on prepayment penalties or balloon payments, and does not take into account how long a rate is locked for. This means that if you are comparing a 30-year fixed rate mortgage and a 5 year adjustable rate mortgage, the different APR measure will not account for the fact that the 30-year rate is locked in for the entire duration of the loan.
Finally, when an APR refers to a variable-rate product tied to a financial index, the APR calculation assumes that the index will remain the same for the duration of the loan. This, of course, is not the case as financial indexes will rise and fall and the actual interest rate paid could vary significantly as a result of these changes.
When and How to use APR
Because of the problems with APR, it is important to understand its limits and its uses. APR is best used for borrowers shopping for a mortgage who intend to keep the mortgage for a long period of time, and who are getting a standard mortgage loan as opposed to a cash out refinance, a home equity loan or a no cost mortgage. You may also wish to use online APR calculators to determine your actual APR, taking into account all fees and costs, rather than relying on the APR numbers provided by your lender.
With these parameters and caveats in mind, APR can be a better way to compare loans among lenders than interest rate and can be one of several factors you evaluate in determining which mortgage loan is right for you.