Lenders are required by law to provide an interest rate for a loan as well as the APR, or annual percentage rate, when mortgage rates are advertised. The APR is meant to make it easier for you to compare loan quotes with a way of comparing not only the interest rate, but the closing costs as well.
The APR reflects the annual cost of the home loan as a percentage of the loan amount. The annual percentage rate includes the interest rate plus mortgage insurance, points, and many lender charges, but not third-party charges. You will notice the APR is higher than the interest rate, but the difference will depend on the loan and the lender. This is why it is important to look at the APR for your loan quotes.
Unfortunately, many borrowers can be misled by the APR because there is no standard as far as what should be included. One lender may include title fees, for example, while another does not. Remember as you compare mortgage quotes that you do not know exactly which fees the lender is including, although some fees are almost always excluded, particularly third-party fees like appraisal fees.
The APR for a loan quote can also be misleading because the calculation assumes you will hold the loan for the full term. If you have a 30-year mortgage, your quoted APR assumes that you do not refinance, sell the home, or make any extra payments during this entire time. The APR calculation also does not consider inflation. This basically means closing costs are amortized over the life of your loan.
Finally, the APR on an adjustable rate mortgage (ARM) is almost meaningless because no one knows what your interest rate will be when your loan resets, which may be as soon as one year later.
As you shop for a home loan, keep in mind that the loan with the lowest APR is not necessarily the best deal, unless you are sure you will keep the loan for the entire term and never refinance or pay extra.
As an example, assume you are taking out a $100,000 30-year fixed mortgage at 5%. Lender A charges $1,000 in closing costs and Lender B charges $4,000. The APR for the first example will be 5.09% compared with 5.35% with Lender B. While the first loan may seem like the best deal, keep in mind that selling your home 5 years later makes the APR climb to 5.41%.
Despite its limitations, the APR is a good way to compare loan quotes. Use it along with the Good Faith Estimate from your lender after you apply to better understand the cost of your loan.