When you take out a mortgage, you have many numbers thrown at you. Interest rates, APRs, and closing fees are just a few. How do you know which number to look at? Is one a better indication than the other? The two we will focus on here are interest rate and the APR. These are the two most confused numbers. Read on to learn more.
The Interest Rate
First, let’s look at the interest rate. This is the rate you hemmed and hawed over when it came time to lock a rate. Chances are you wanted the lowest rate possible. Maybe you held out until that magical rate came. Or maybe you gave in and locked a rate because you were afraid of increasing interest rates. No matter the case, this is an important number.
The interest rate is the portion of your loan that you pay in addition to the principal. Let’s say you borrowed $100,000 for simplicity’s sake. The interest rate you locked was 4%. This means you pay $333.33 in interest charges at first. Your total payment equals $477.42, though.
$477.42- $333 = $144.42 paid towards principal
Next month, you only owe interest on $99,855. While not much of a difference, it decreases the amount of interest you owe a little. The 2nd month you will owe $332.85 in interest. The amount you pay in interest goes down each month as you pay the principal down.
If you have a month you can pay a little extra towards the principal, you can decrease the interest you owe even more. You can make extra payments when you can afford to or on a regular basis. Some borrowers even make bi-weekly payments. They divide their monthly mortgage payment in half. This way they pay half of the amount due one week and the other half another week. This decreases the average daily balance of the loan. Over the life of a 30-year term, you could shave off 4 years and $10,000 in interest!
Now, let’s look at the APR. This is short for Annual Percentage Rate. This calculated rate includes the cost of the loan. Some of the usual costs included are:
- Discount points
- Origination points
- Credit reporting
- Title fees
- Inspection fees
- Attorney fees
This is just a sampling of what may be included. Basically, it’s any fees that have to do with the loan. This will vary by lender.
The lender calculates the APR by including the cost of the fees. We’ll use the same $100,000 example:
$100,000 loan at 4%
Fees included in APR = $3,000
The loan amount used for the APR calculation equals $103,000. This comes out to an APR of 4.246%.
Whether you should focus on the APR or not is a highly debated topic. You should use what you are comfortable with when finding the right offer. Here’s why using only the APR might not be right:
- Lenders can pick and choose what they include in the calculation
- You may not keep the loan for the entire term
- You may have better use for the costs you would pay upfront
You can ask a lender to break down the costs they include in their APR. They have to tell you. This way you can lay offers side-by-side to see how they compare. For example, one lender may offer a low interest rate, but load you up with fees. This creates a lower APR than the loan with a higher interest rate and lower fees. If you jump at the loan with the higher fees, you could pay more than you wanted. Here’s why.
You might not stay in the home for 30 years. That is what the APR calculation assumes. Even if you do stay in the home, chances are you will refinance. Again, this throws the previous calculations out the window. If you paid the large fees upfront, you might not have hit your break-even point yet. This is the point where you pay off your closing costs and enjoy the lower interest rate.
Think of the Future
A better plan is to think of the future. How long do you see yourself staying in the home? Do you think you’ll refinance in the future? Do you have the money to pay the costs up front?
If you have the money, consider if you have better uses for it. For example, you might need more money saved for retirement. Putting the cash in that type of investment vehicle may have a better pay off. Yes, your interest rate might be higher, but if it only affects your payment between $50-$100, is it worth thousands of dollars upfront?
These are the things you should consider. Lenders can easily sway their APRs, making them look much more attractive than they actually are. Only you know what works for you. The best way to do it is to talk to several lenders. Tell them you want to know everything that goes into the APR. Then negotiate those fees. Many lenders have wiggle room. They would rather gain your business and knock a little money off than lose it altogether.
Of course, you should look at the big picture too. Your locked in interest rate affects your payment. This, in turn, affects your debt ratio. Maybe you wouldn’t qualify for a loan with the higher payment. Then the decision is a no-brainer, assuming you can afford the closing costs. If you do qualify and you have options, though, think it through carefully. If you know you will pay the loan off faster, think of the long-term effects. Closing costs amortized over 7 years rather than 30 makes a big difference.
Take your time and compare offers as closely as possible. This way you can make the right decision for what could be the largest investment of your life.