The two things every mortgage borrower should focus on are: 1) the interest rate, and 2) the cost to refinance or take out a new mortgage.
But the interest rate is online the headline number. The APR, or Annual Percentage Rate, is what really matters.
The APR includes the interest rate as well as other fees and costs, and is expressed as a percentage. The interest rate only includes interest paid to the bank.
Mortgage APR versus Mortgage Interest Rate
The difference between an APR and an interest rate is that an APR gives borrowers a truer picture of how much the loan will cost them.
Although an APR is expressed as rate just like interest, it is not related to your monthly payment — which is calculated using only the interest rate. Instead, an APR reflects the interest rate along with fees and other one-time costs a borrower will pay to get a mortgage.
My favorite type of mortgage is a “no cost mortgage” where all the fees are baked in. In other words, you won’t have to pay anything out of pocket to get your mortgage. However, know that there is no free lunch.
For the privilege of getting a “no cost mortgage,” you end up paying a slightly higher interest rate e.g. 3.125% versus 3%.
You need to be careful about lenders luring you in with a very low interest rate. What you need to really do is see what their APR is. It’s kind of like seeing an amazing car deal in the newspaper, where in little fonts it says “only one at this price” to get you in the door.
Here’s a great infographic from MagnifyMoney highlighting the differences between APR and interest rate.
How The APR Affects Mortgage Cost
To calculate an APR, the lender adds the fees and costs to the mortgage interest rate and creates a new price for the loan. Here’s an example:
A lender approves a $1,000,000 mortgage at a 4.5% interest rate. The borrower decided to buy one discount point, which costs $10,000, to get the 4.5% rate (a discount point is a fee paid to the lender in exchange for a reduced interest rate). The loan also includes $4,000 in fees, which are being financed in the mortgage.
With the fees and costs mentioned above added to the loan, the adjusted starting mortgage balance becomes $1,014,000. The monthly payment (which consists of the principal plus interest) is then $5,138 with the 4.5% interest rate, compared with $5,067 if the balance had remained at $1,000,000.
To find the APR, the lender returns to the original loan amount of $1,000,000 and calculates the interest rate that would create a monthly payment of $5,067. In this example, that APR would be approximately 4.661%.
Again, if the interest rate and the APR are roughly the same, the lender is charging any fees on the loan. Your goal is to take out a mortgage that has an APR as close to the interest rate as possible.
The Various Fees That Raises The APR
Below are some of the common fees that affect APRs:
- Discount points: Lenders allow buyers to purchase points in return for a lower interest rate. The cost of a point is equal to 1% of the mortgage amount and typically lowers the interest rate on the loan by an eighth of a percentage point. For example, a buyer approved for a $1,000,000 loan could buy three points, at $10,000 each, to lower the interest rate from 4.5 to 4.125.
- Loan origination fees: Loan origination fees typically average about 1% of the loan amount. This cost can be especially significant for larger loans.
- Loan processing: This fee, which some lenders will negotiate, pays for the cost of processing a mortgage application.
- Underwriting: These fees cover an underwriter’s review of a loan application, including the borrower’s income, credit history, assets and liabilities and property appraisal, to determine whether the lender should approve the loan application and what terms should be applied to the loan.
- Appraisal review: Some lenders pay an outside reviewer to make sure an appraisal meets underwriting standards and that the appraiser has submitted an accurate report of the home’s value.
- Document drawing: Lenders often charge a fee for creating mortgage documents for a loan.
Here’s a graphic that highlights all the different types of fees I had to pay when I refinanced a $700,000 loan. The lender actually gave me a credit of $3,800, which means all my fees were paid for and then some that went towards pre-paid interest.
Closing costs that aren’t commonly in an APR calculation are notary fees, credit report costs, title insurance and escrow services, home appraisal, home inspection, attorney fees, document preparation and recording fees.
How To Get The Lowest APR Or Interest Rate Possible
If you’re going to get a new mortgage or refinance a mortgage, you should strive to get the best interest rate possible. The #1 determining factor for getting the best interest rate possible is your credit score.
You need a credit score of at least 760, if not 800+ nowadays to get the best rate. Banks have really gotten more stringent since the financial crisis in 2008-2010. Here are other determining factors.
Down payment: You need a minimum of a 20% downpayment on your primary residence and a 30% downpayment on a rental property to get the best rate.
The loan term: Because the yield curve is generally upward sloping due to the time value of money, the longer your duration, the higher your interest rate. For example, a 30-year fixed loan is almost always higher than an Adjustable Rate Mortgage. I prefer an 5 to 10-year ARM because rates are lower and the average ownership of a house is only 9 years.
The loan amount: Conforming loans are generally cheaper to finance. However, there are times when jumbo loans are cheaper. After you get to the super-jumbo range, the cost could get higher, depending on your credit quality.
The loan type: While many borrowers apply for conventional mortgages, the federal government offers loan programs through the FHA, USDA and VA that may have lower interest rates. You can have a credit score as low as 510 for an FHA loan, and 620 for a Fannie and Freddie-backed loan.
The type of property: Principal residence mortgage loans are the cheapest. Interest rates are generally 0.5% – 1% higher for rental properties and commercial properties.
Take Advantage Of Lower Mortgage Rates Today
Interest rates have been trending down since the late 1980s. Don’t believe me? Check out this graphic below.
There is one absolute best time to refinance your mortgage, and that is when the yield curve inverts. You are essentially getting the best bargain for the duration where there is an inversion. For example, if the 5-year, 7-year, or 10-year bond yield is lower than the 3-month bond yield, then you should try and get a 5-year, 7-year, or 10-year ARM and save money in 3-month bonds to take advantage of the arbitrage.
Check the latest mortgage rates online through Credible. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible from them or your existing bank. Credible allows you to compare multiple real quotes, all in one place for free. When banks compete, you win.
When rates are collapsing, you should also consider investing in real estate. Lower interest rates make real estate more affordable, which brings in more buyers.
My favorite way to invest in real estate is through Fundrise, the top real estate crowdfunding platform today. You can invest as little as $500 in commercial real estate that was once only available to institutional investors and ultra-high net worth individuals.