What is annual percentage rate and how does it work in real estate?

When you take out a mortgage, you’ll likely come across some unfamiliar financial acronyms. One of them is APR, which stands for annual percentage rate. APR is like your interest rate in that it tells you how much your loan will cost but it’s measured differently and includes other fees.

Before you commit to a lender, it’s important to wrap your head around APR so that you can compare offers and choose the mortgage with the best terms.

What is APR?

APR is the yearly cost of a loan expressed as a percentage. APR includes your interest rate and any additional fees you’ll be charged. As a result, APR is a more comprehensive measure of how much you’ll pay for a mortgage. The APR you’re offered will depend on factors including your credit score, down payment, loan amount, loan term, and market conditions.

APR vs. interest rate

The biggest difference between your loan’s APR and interest rate is that the APR includes any fees you have to pay your lender or another party. The interest rate reflects only the interest you’ll pay. Because your APR includes these fees, it will always be slightly higher than your interest rate and is a more accurate measure of how much your mortgage costs.

Types of APR

When you borrow money or apply for a credit card, you’ll encounter two types of APR: fixed and variable.

Fixed APR

A mortgage with a fixed APR comes with an interest rate that gets set when you take out the loan and never changes. As a result, you can bank on having a predictable monthly payment and you can budget for the future. A fixed-rate mortgage can be particularly beneficial if you take out your mortgage when interest rates are low.

Variable APR

A mortgage with a variable APR comes with an interest rate that changes over time, rising or falling along with market conditions. A mortgage with a variable APR, better known as an adjustable-rate mortgage or ARM, starts with a lower interest rate than a fixed-rate loan. After a few years, usually 5 or 7, the introductory period ends, and your monthly payment will adjust – typically once a year.

This means that your monthly payment will increase or decrease each year you pay off the loan. Lenders usually cap how much your interest rate can increase or decrease over the life of the loan.

If you take out a mortgage with variable APR, it’s very important that you’re prepared for your monthly payment to increase. Be sure you know how soon your payment could increase, how high or low your payments can go, and how frequently your rate adjusts.

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 fees to the same loan. The fees that factor into your APR typically 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 interest rate you’re charged will vary depending on your credit score, market conditions, and other factors. The higher your rate, the higher your monthly payments.
• Underwriting fees: Underwriting fees cover the costs of reviewing your finances to determine your eligibility for the loan and ability to pay it back. 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.
• Document preparation fees: Lenders typically charge fees for preparing the documents that you’ll sign at your loan’s closing.
• 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. You can expect closing costs to range from 3% to 6% of the total loan amount.

You’ll find out what APR you qualify for when you receive your Loan Estimate. All lenders are required to use a standardized Loan Estimate form so that you can compare the APR or other loan terms from different lenders to help you pick the best deal.

How to calculate APR

If math isn’t your strong suit – don’t worry – you won’t have to calculate APR on any mortgage you apply for. Lenders are required to provide this information to you. However, it can be helpful to know where this percentage figure comes from and the factors that affect it.

Here’s the formula to calculate APR:

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

It’s easier to give an example on a smaller loan. Let’s say you’re taking out a personal loan for $2,000 and the loan’s repayment term is 180 days. Your lender is charging you $120 in interest and $50 in fees.

1. Add the fees and total interest. 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. So, $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 stay with us. You’ll 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.

Why is APR important?

APR is an important figure because it tells you how much your loan was going to cost you. It’s also a useful number when comparing loan offers to help you find the least expensive one.

As you consider loan offers, be careful not to mix up APR and interest rate. You’ll want to avoid comparing the interest rate of one loan to the APR of another, as these are two separate figures.

Let’s say one lender offers you a mortgage loan with 5% interest but an APR of 7.45%. Suppose 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 up front 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.

Annual percentage rate FAQs

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. If the average APR for a 30-year fixed rate loan is currently 6.98% and you’re offered a mortgage at 6.5%, that’s quite good for the current market. However, if the average APR were currently 3%, a 6.5% APR wouldn’t be so good at all.

Does my credit score affect my APR?

Your credit score has a big impact on the APR you’re offered. Borrowers with higher credit scores tend to get offered lower interest rates, which in turn means a lower APR. If your credit isn’t so great, you can expect a higher interest rate and higher APR.

What’s the difference between APR and APY?

APY stands for annual percentage yield and is very different from APR. Instead of measuring how much you’ll spend each year on a loan, APY 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 tells you how much you’ll earn on them each 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. As you compare loan offers, remember to distinguish between a loan’s APR and interest rate. A loan with a lower interest rate than another may cost less in interest, but if it has a higher APR, it comes with more up-front fees. Shopping around can help you find the loan with the lowest APR you can get.

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