Ask Stacy: What’s the Difference Between Mortgage Rates and APRs?

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This week’s question is short, but it’s super-important, especially if you’re shopping for a mortgage. Here it is:

To all at MoneyTalksNews,
Thanks for all of the interesting and useful information you share. I was hoping to get a layperson’s explanation of what APR is in regards to mortgages. — Kerry

While Kerry’s query may appear basic to those with experience, it’s a good question. According to a recent survey by Zillow, more than a third of first-time homebuyers don’t know what “APR” means. (There’s more that first-time homebuyers don’t know; see “Study: People Don’t Understand Mortgage Basics.”)

What’s an APR?

APR stands for annual percentage rate. Here’s the definition from Investopedia:

The annual rate that is charged for borrowing, expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.

It’s a decent definition, but when it comes to mortgages, it’s not totally right.

Before I explain why, let’s get into a little more detail.

An APR includes fees

Look at a mortgage search, and you’ll note APRs are always either higher or the same as the rate — never lower. Here’s an example from the Money Talks News mortgage search:

Mortgage Rates

The reason APRs can never be lower than rates is because they include both the rate and some of the fees involved in securing the loan.

Simple example: Say I lend you $100 for a year at 10 percent interest. At the end of the year, you’ll owe me $110: the original $100, plus $10 interest. But what if I also charge $1 to process the paperwork? In that case, your total cost of the loan would be $11, or 11 percent. In this example, the rate was 10 percent, the APR, 11 percent.

This is why, when it comes to searching loans, most people shop the APR, not the rate, because the APR more accurately reflects what you’ll actually be paying. Note I’m saying “more accurately,” not “accurately.” That’s because …

The APR doesn’t include all the fees

As I said, the Investopedia definition of APR above is decent, but not exactly right. That’s because they said the APR “includes any fees or additional costs associated with the transaction.” But when it comes to mortgages, that’s not true: The APR doesn’t include all the fees. And that’s where things get tricky.

While the APR will include fees like discount points (an up-front charge to get a lower rate), mortgage insurance, broker fees, application fees, settlement fees and many others, it doesn’t include everything. Fees for things like appraisals, credit checks, title search, title insurance, and notary and recording fees often aren’t included in the APR. To make matters more confusing, there’s no regulation stating what expenses must be included, which makes apples-to-apples comparisons difficult.

So what’s a rate shopper to do? Here’s a video I shot a few years ago when I refinanced my house, explaining exactly what I did to get the best mortgage at the lowest cost. Check it out, then read on.

To recap, here are the steps I took:

  • Shopped online (you can start your search with our mortgage search). 
  • Found three to five lenders offering the lowest APRs.
  • Called each lender and asked for a complete listing of every fee.
  • Compared each quote, and pitted lenders against one another to get fees reduced or eliminated.
  • Before closing the loan, I carefully examined the closing statement to make sure I got what was promised.

Bottom line? Understanding how mortgages work is critical before you start shopping. That means not only knowing about things like APRs, but being prepared to fight back against a blizzard of “garbage” fees. The process may seem intimidating when you start, but it’s not that big a deal. Make a spreadsheet so you can quickly compare offers, then pit lenders against each other to get the best deal.

Got a money-related question you’d like answered?

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The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.

Got any words of wisdom you can offer for this week’s question? Share your knowledge and experiences on our Facebook page.

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