Why Is The APR On´┐ŻA Mortgage Higher Than The Interest Rate

By Gina Pogol
Mortgage Credit Problems Columnist

Mark Asks: Dear Gina, I am shopping for a mortgage (I have bad credit so it isn't easy) and when I look at the forms I always see that the APR rate is higher than the interest rate. Which rate should I be looking at when I compare mortgages? Why is APR higher?

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Gina Says:

Hi Mark,

Those are excellent questions. Let me start by explaining what APR is.

What is APR?

It stands for annual percentage rate, and all it does is incorporate the costs of getting the mortgage into an annual rate. It's supposed to make shopping for a bad credit or other mortgage easier. For example, if you were offered a 6% home loan at a cost of two points or a 6.5% home loan at no costs, how would you know which loan was better? By using an APR calculator, you'd input your loan amount, costs, and the interest rate, and voila! You'd see which one costs more. In this case, the 6% loan costing 2 points has an APR of 6.19%, while the no cost loan has an APR of 6.5%.

But wait, there's more

So is the loan with a 6.5% APR the better deal? Maybe not. APR calculations assume that you keep the loan for its entire term. But what if you only keep that 6% 30-year mortgage for five years? Its APR changes to 6.83% (because your upfront costs are spread over only five years, not thirty)! In general, if your time frame is short or if you don't know how long you will keep your loan, those with lower upfront costs might be the better deal for you.

APR isn't always higher than the stated interest rate

When you look at home loans for people with bad credit, the APR is nearly always higher than the stated rate because these loans tend to have "teaser rates" that are then raised significantly higher in a few years. But adjustable rate mortgages for people with good credit have APRs right now that are lower than the stated interest rate. Why? Because short-term interest rates are so low today that, unlike most of the time, loan rates are adjusting down from their start rates, not up. So APR calculations for these loans incorporate their start rates, say 4%, and work on the assumption that they will adjust to today's levels, say 3%. The result is an APR that is lower than the stated interest rate.

No cost loans

Finally, no-cost loans, those with no points or fees, should have APRs identical to their stated rates, because no costs are being integrated into the total cost of borrowing. The only charge for borrowing in that case is the interest. Of course, no cost loans do come at a cost--a higher rate. It's up to you to decide if the higher rate is worth avoiding upfront lender fees and other charges.

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