Note Rate vs. APR
Many clients have asked me, “what is the difference between the Interest Rate of a mortgage loan, and the APR, or annual percentage rate of a mortgage?” The interest rate, or the note rate, is simple. This is the interest rate that determines your monthly principal and interest payment amount. The APR formula, however, considers the costs incurred to borrow at that specific note rate over the life of the loan, and expresses this as a yearly percentage. The Federal Truth in Lending Disclosure Statement is the document that contains the APR. The APR is really only accurate when looking at fixed rate mortgages, not ARM loans as any prediction on how interest rates will adjust over the life of an adjustable rate mortgage is simply a guess. Also keep in mind that some 3rd party costs such as the appraisal report and credit report are not included in the APR formula, while lender costs such as origination and discount points, prepaid mortgage interest, underwriting, processing, administration, application fees, etc. all are.
As many consumers are more interest rate conscious, some lenders may charge some or all of these lender fees at various amounts to “buy down” the interest rate, and appear to have lower rates than another lender quoting the “par rate” or “market rate”. Basically, cost and rate have an inverse relationship. A mortgage loan with a lower interest rate may actually have a higher APR, and vice versa. If you’ve heard of “paying points” to buy down an interest rate, or the other extreme of taking a higher interest rate on a “no cost” or “no fee” loan, these are both examples of this. When considering these options, it is best to calculate your break-even point to help decide which loan structure best meets both your short term and long term objectives. For example, lets take a look at two 30-year mortgage loans.
Loan A has a monthly payment of $985 and a lender cost of $2,500, and loan B has a monthly payment of $1,025 and a lender cost of $500. To calculate your break-even point you would divide the additional cost of Loan A into the savings in monthly payment offered by loan A ($2,000 / $40 = 50), and then divide that number by 12 to determine your break-even point in terms of years. In our example your break-even point would be at 4.17 years, so at that point your cost for the buy-down would be fully repaid. I always ask my clients to also consider the opportunity cost of a rate buy-down…if there is a more attractive investment or savings alternative with keeping the additional funds liquid and available…or if they would just spend it! For a shorter term analysis, it’s best to compare the payment amount relative to the upfront costs of a loan as we did here, as the APR assumes that you will keep the loan for its full duration, ie: 15 years, 30 years, etc.
The good news is that being in a strong “buyer’s market” a good buyer’s agent is often times able to negotiate for the seller to pay all of their closing costs as well as pay for an interest rate buy-down. The other good news is that mortgage interest rates are at historically low levels, but they won’t last for long. My advice: A mortgage is most likely the largest amount of money you will borrow in a single given period of time, so be a smart consumer…ask questions and get answers! DO NOT work with a lender who cannot fully explain the details of your loan to you and DO NOT work with a lender who is misleading when it comes to costs of a loan or interest rates. DO work with a professional lender who is knowledgeable, upfront, and who will take the time to present to you all of your options in meeting both your short term and long term financial objectives.
Please don’t hesitate to call me if you are considering purchasing or refinancing a home, or simply have questions regarding home financing. I am glad to be of service.
Sr. Loan Officer
Home Loan Division