What is APR? Aramco Mortgage explains...
Anyone who has ever heard an advertisement for a mortgage company trying to garner your business (which should be everyone reading this, unless your closest neighbors are cattle) should be quite familiar with the term “APR.” But what exactly is the APR? What is the difference between APR and the actual interest rate on a mortgage?
To put it simply, APR is a way of allowing the consumer to compare different loan scenarios side by side. It enables one to calculate upfront costs, break even points, and savings into their decision making process. A normal interest rate of say 4% for 30 years, merely defines what rate of interest will be owed to the bank during the life of the loan. But APR annualizes the closing costs, mortgage insurance, loan fees, and various other costs of transacting the loan.
Let’s use an example. Say your mortgage broker (which should of course be Aramco Mortgage) offers you two different 30 year fixed rates:
3.625% with no points and no closing costs
3.5% with $5,000 in closing costs.
It’s tough right off the bat to determine which loan product is the best deal. Of course, the first step your loan professional should take is to determine the break-even point with option B. Let’s say the Home Value = $450,000 and the Loan Amount = $300,000. At 3.625% the monthly payments would be $1,459, while at a rate of 3.5% the payments would equal $1,436, a savings of $23 a month. Thus, taking into account the $5,000 closing costs needed to buy the rate down, it would take 217 months or 18 years to break even. Of course, this is a bit complicated and time consuming to go through constantly, so APR allows us to compare the two loan programs much quicker.
Aramco Mortgage’s rate of 3.625% would also have an APR of 3.625% due to the lack of closing costs, while the 3.5% rate would actually have an APR of 3.636% once costs are factored in. Of course the difference is minimal, and no loan professional can really make the decision for you as far as which program is best, but the APR allows you to compare two very different situations. One situation may be better in the short-term, if one doesn’t have the cash to pay closing costs, while the other situation might be best for someone planning to stay in their home the rest of their lives and who does have the cash to pay closing costs up-front.
While APR is definitely a helpful tool, it is far from perfect, as it leaves out some costs such as application fees, late payment charges, title examination, appraisals, and insurance premiums. As a general rule, APR is more important to look at if planning to stay in the home for the life of the loan, and less important if you plan to sell or refinance again in the near future. Stay tuned for more terms and common questions answered by Aramco Mortgage, or if you have any nagging questions that you’d like us to answer in a future blog don’t hesitate to leave a comment or send us an email.