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What Is Annual Percentage Rate (APR) And How Does It Work In Real Estate?

May 15, 2024 7-minute read

Author: Dan Rafter

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During the mortgage process, home buyers typically hear and see many terms from lenders – and one of those terms is APR, or annual percentage rate. Like the interest rate, the APR provides a borrower with an accurate measurement of the loan’s cost, but in the case of APR, it’s annually.

Before you commit to a lender and a particular loan, it’s important to know what APR is exactly and how it can affect your future mortgage payments. By recognizing the best APR offer for your finances, you can set yourself up with an affordable mortgage loan.

What Is APR?

APR represents the yearly cost of borrowing money and interest rate plus additional fees.

APR provides the best measure of how much borrowers pay for mortgage loans each year. It’s an even more effective tool than the interest rate of measuring your loan’s annual cost.

Why? Because your APR doesn’t just include how much you’ll pay in interest for your mortgage. It also includes several other fees, to give you the total cost – not just the amount of interest you’ll pay – of your loan.

APR Vs. Interest Rate

The biggest difference between your loan’s APR and interest rate is that the APR includes both  interest rate and any fees that your lender and other providers charge while originating your mortgage. An interest rate doesn’t include any fees but represents only the cost of borrowing money from a lender.

Because your APR includes lender fees and represents your rate for the year, it will always be higher than your mortgage’s interest rate and provide a more accurate view of how much your mortgage costs.

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What Does APR Include?

When shopping around for the best APR, it’s important to remember that every lender is different and likely won’t apply the same exact fees to the same loan. The fees that factor into your APR usually include:

  • Base interest rate: Your lender will charge you interest on the money you borrow and will use that interest rate when calculating your monthly payments. The higher your rate, the higher your monthly payments.
  • Document preparation fees: Your lender usually charges fees for preparing the documents that you’ll sign at your loan’s closing.
  • Underwriting fees: Underwriting fees cover the costs of the research that your lender’s underwriters perform when determining if you’re willing and able to cover your new mortgage payment. Underwriters will review your credit score, bank statements, W-2s and paycheck stubs to verify your income and history with paying your bills.
  • Origination fee: The origination fee is the money you’ll pay your lender for the work they do to process and fund your loan application.
  • Closing costs: Closing costs include all the fees you pay to your mortgage lender and the third-party providers – including title insurers, real estate attorneys, inspectors and appraisers – that work on drafting your new mortgage.

To find out what APR you qualify for, it’s important to apply for a mortgage early on in the home buying process. Not only will this help you learn about your monthly payments, but it’ll guide the price range you should stay within while house hunting.

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Apply online for expert recommendations with real interest rates and payments.

How Does APR Work?

Considering your loan’s interest rate by itself won’t help you determine the cheapest lending option. APR, on the other hand, shows you the total cost of borrowing by including all applicable charges so you know exactly what you’ll pay when comparing offers from multiple providers.

That’s why it’s important to understand that various factors, some of which you can’t control, impact APR. Others, however, are very much within your control as a borrower.

Here are some of the factors that determine how high or low your APR will be:

  • Credit score: Your three-digit credit score is a snapshot of your credit profile. The higher this score, the more likely you are to qualify for a lower interest rate and APR. Improve your credit score by paying your bills on time each month and paying off as much of your credit card debt as you can.
  • Debt-to-income ratio (DTI): Most lenders prefer that your total monthly debt payments, including your new mortgage payment, equal no more than 43% – 50% of your gross monthly income. You’re more likely to qualify for a loan with a lower interest rate – and lower APR – if you have a low DTI.
  • Prime rate: The prime rate is the interest rate that banks and other lenders charge borrowers. Banks and lenders will usually charge a higher interest rate the higher the prime rate, raising your mortgage’s APR.
  • Fees: Lenders often charge fees on top of an interest rate, raising the cost of your APR. You can limit this cost by shopping for a lender with low fees.
  • Loan type: Mortgage and auto loans typically come with a relatively low APR since lenders use your home or car as collateral to secure the loan. Unsecured loans, such as personal loans and credit cards, are often seen by lenders as riskier, resulting in a higher APR than a secured loan where collateral is required. 

What Are The Different Types Of APR?

You’ll encounter two main types of APR – which we’ll discuss next – when borrowing money or applying for a credit card.

Variable

A mortgage or loan with a variable APR comes with an interest rate that can change over time, rising or falling according to whatever economic index the loan is tied to.

A mortgage with a variable APR, better known as an adjustable-rate mortgage, typically starts with a lower interest rate than what you’d get with a traditional fixed-rate loan. After a certain number of years, usually 5 or 7, the loan enters its adjustable period during which its interest rate will change – typically rising or falling once a year.

Fixed

A loan or mortgage with a fixed APR comes with an interest rate that doesn’t change. The interest rate on your 30-year or 15-year fixed-rate mortgage will remain the same from the first day of your loan all the way to the last.

If you find yourself struggling to choose between a variable and fixed-rate APR, you can prequalify or apply for initial approval for both an ARM and a fixed-rate loan to compare monthly payments before committing to either one.

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How To Calculate APR On A Mortgage

You won’t be required to calculate the APR on any mortgage for which you’re applying. Lenders will provide this information to you, making it easier to shop around for the lowest-priced mortgage.

But if you want to delve into the math, here’s how to calculate APR on your own:

APR = [({Fees + Total Interest} ∕ Loan Principal) ∕ Total Days in Loan Term] ✕ 365 ✕ 100

Because it’s easier to give an example on a smaller loan, suppose you’re taking out a personal loan for $2,000 and the loan’s repayment term is 180 days. Suppose, too, that your lender is charging you $120 in interest and $50 in fees.

  1. Add the fees and total interest. Your first step is to add your interest and fees. That's $120 plus $50, which comes out to $170.
  2. Divide that sum by the loan principal. Next, divide that $170 by your loan’s principal balance of $2,000. The math will look like this: $170 / $2,000 = 0.085.
  3. Divide that result by the total days in the loan term. The math gets a little tricky here, but now divide that 0.085 by the number of days in your loan’s term, 180. This time, the math looks like this: 0.085 / 180 = 0.00047222.
  4. Multiply that result by 365. Now multiply the result from step 3 by 365. This equation works out like this: 0.00047222 ✕ 365 = 0.1723611.
  5. Multiply that result by 100. Finally, multiply the figure from step 4 by 100 to get a percentage. In this case, you’d get 0.1723611 ✕ 100% = 17.24%. That final percentage is your APR.

If this math seems complicated, don’t worry. Again, your lender will have already calculated your APR for you when you apply for a loan.

You can also rely on the calculator below to quickly work out a loan’s APR without doing the math yourself. Just plug in your loan’s interest rate, term, principal balance and other key figures.

Why Is APR Important?

APR is important because it’s the best way to find the lowest-cost mortgage by easily comparing offers between lenders.

Let’s say a lender offers you a mortgage loan with 5% interest but an APR of 7.45%. Now let’s say another lender offers you a mortgage with a higher interest rate of 6%. You might think the first mortgage is less expensive, but if the second loan comes with an APR of 7.37%, it’ll cost you less upfront than the loan with the higher interest rate.

Closing costs and fees are the reason the second loan has a lower APR even though its interest rate is higher. The first lender is charging more in fees, making its loan more expensive even with a lower interest rate.

The chart below gives a visual explanation of how you can compare offers and save money.

Loan Amount

$100,000

$100,000

Term

15 years

15 years

Interest Rate

5%

6%

APR

7.45%

7.37%

Discount Points

2

2

Origination Fee

5%

5%

Other Fees

$10,000

$2,000

Annual Percentage Rate FAQs

Understanding APR and interest rates can be tricky. Here are answers to some of the most common questions that borrowers have about annual percentage rate.

What is considered a good APR for a mortgage?

What makes for a “good” APR varies according to several factors, including the strength of your credit score, the type of mortgage you take out and whether mortgage interest rates are high or low when you’re applying for financing. For instance, your APR will generally be lower if you take out a shorter-term, 15-year loan instead of a 30-year fixed-rate loan.

Does my credit score affect my APR?

Your credit score can cause your APR to rise or fall. Usually, your mortgage loan will come with a lower APR if your credit score is higher.

What’s the difference between APR and APY?

APY stands for annual percentage yield, and instead of measuring how much you’ll spend each year on a loan, it measures how much money you’ll earn each year from interest on an investment. Maybe you’ve invested money in a CD, money market account or high-yield savings account. The APY on these investment channels states how much you’ll earn on them in a year.

The Bottom Line: Look For Home Loans With A Low APR

If you’re searching for a mortgage loan, pay attention to the APR that lenders quote you. It’s the best way to find the lowest-cost home loan since it combines both the mortgage’s interest rate and the lender’s fees.

Are you ready to begin your hunt for an affordable mortgage? You can start the mortgage process with us.

 

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Dan Rafter

Dan Rafter has been writing about personal finance for more than 15 years. He's written for publications ranging from the Chicago Tribune and Washington Post to Wise Bread, RocketMortgage.com and RocketHQ.com.