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
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
Lender B offers a lower interest rate (or "nominal
rate"), but for $2,000 more in points and
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
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