Understanding mortgage APR

When you apply for a mortgage, the lender is required to tell you the interest rate and the annual percentage rate, or APR.

But what exactly is the APR?

The APR is designed to help you shop for loans by making them more comparable.

"It's the one common denominator by which you can compare loans side by side, comparing apples to apples to apples," says David Newton, an economics professor at Westmont College in Santa Barbara, Calif.

How to rate a mortgage
As Newton explains it, APR measures the net effective cost of borrowing -- "the actual present value of those funds over the length of the contract." In other words, APR answers the question: "Is it worth it to pay more upfront to get a lower rate?"

The federal government requires lenders to quote APR because loans frequently are offered on different terms. To extend the inevitable fruit analogy, differing loan terms from different lenders can make it hard to figure out which offer is a sour persimmon and which is a real peach. APR helps you identify the peaches.

For example, you might get the following two quotes for $150,000 mortgages, each for a 30-year term:

Lender A offers 6.5 percent with the borrower paying no discount points and $5,000 in fees;
Lender B offers 6.25 percent with the borrower paying 1 discount point ($1,500) and $5,500 in fees, for a total of $7,000 in points and fees.
Lender B offers a lower interest rate (or "nominal rate"), but for $2,000 more in points and fees.

Which is a better deal? APR gives you a general idea.

Lender A's offer has an APR of 6.83 percent, while Lender B's offer has an APR of 6.71 percent. Since Lender B's APR is lower, that loan is a better deal in the long run.

But that's in the long run.

Consider the term
In the short run, Lender A's offer might be better. A look at the examples above tells why.

Lender B's offer carries a lower APR, but you, the borrower, have to come up with $2,000 more in cash. What if you don't have the money, or you have it, but need it to buy appliances? In those cases, you might prefer the first loan, despite its higher percentage rate and APR.

Or what if you think you might move within a few years? Loan A costs $948.10 a month in principal and interest -- $24.52 a month more than Loan B. So with Loan B, you pay $2,000 up front to save a little less than $25 a month. At that rate, it takes 82 months -- more than 6.5 years -- to recoup the $2,000. If you sell the house in less than 82 months, Loan A costs less.


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