Untangling mortgage interest rates

I don't understand how one loan can have an APR different from its interest rate.

by Walter Updegrave

CNN/Money Contributing Columnist NEW YORK (CNN/Money) - I'm considering refinancing my mortgage, but I don't understand the difference between the loan's interest rate and its APR, or annual percentage rate. How can one loan have the same interest rate but different APRs? -- John Wadlinger, Ossipee, New Hampshire

What? You mean you find it confusing that a loan can have an interest rate of, say, 5.9 percent, but an annual percentage rate, or APR, of 6 percent? Or 6.1 percent? Or 6.2 percent? Now what in the world could be confusing about that?

Seriously, you're not the only person thrown off by the terminology used in the mortgage world. Of course it's confusing! Given the way most people understand the two terms, a distinction between a loan's interest rate and its annual percentage rate makes no sense at all. Why in the world would anyone expect there to be a difference between two terms that seem to be different ways of saying the same thing?

The mysteries of the mortgage world

Ah, but in fact, these two terms mean very different things. Let's start with the interest rate.

The interest rate, also known as the nominal rate, is nothing more than the percentage rate that the lender applies to your loan balance. So if the lender applies a rate of 5.75 percent, the loan's quoted interest rate, or nominal rate, is 5.75 percent.

The APR, by contrast, includes that interest rate, plus the effect of other charges and fees (which is why you'll notice the APR is never lower than the quoted rate). One of those extras is a charge known as "points."

Points are also a form of interest, except that you pay them upfront. That's why you'll sometimes hear points referred to as "prepaid interest." Each point equals 1 percent of the value of the mortgage. So if you take out a 30-year $100,000 mortgage with an interest rate of 5.75 percent and, say, two points, those two points would cost you $2,000, which you would pay at closing.

To calculate the APR, lenders figure the interest you'll pay based on the loan's interest rate and then add in the points. But they don't charge the points to a single year. Rather, the lender effectively averages out the cost of those points over the term of the loan.

So in the case of our $100,000 30-year loan at 5.75 percent with two points, the APR would reflect the effective annual rate of interest you would pay over 30 years by paying 5.75 percent annually on your loan balance plus $2,000 upfront in points. That would bring the APR in this case to around 6 percent or so.

But the APR typically includes more than just points. It also takes into account other loan-related fees, such as mortgage insurance. (It doesn't, however, reflect fees for things like title insurance, the loan application, the appraisal and document preparation fees. The lender should be able to give you a list of fees included in the APR.) The APR vs. the nominal interest rate

The APR puts loans with different terms on a level playing field. Given a choice between a 30-year loan with a 5.75 percent rate, two points and $3,000 in fees versus one with a 5.9 percent rate, no points and $2,000 in fees, most of us wouldn't have the slightest idea which is the better deal. But if we have the APR on both loans, we know that the one with the lower APR charges less over the term of the loan.

That doesn't necessarily mean the loan with the lower APR is the better one for you, however. Why? Because you may not stay in your home the entire term of the loan. Or you may refinance before the term is up.

If you take a loan with high points and fees and then pay it off early, then the money you pay upfront in points and fees will be averaged out over a much shorter time than the period used in the APR calculation. In short, you will have paid a much higher APR than the one quoted by the lender when you got the loan.

All of which means that in addition to comparing APRs, you've got to consider how long you're likely to keep the loan. If you think there's a good chance you'll sell or refinance, a loan that has a higher APR but lower fees may be the better bet.

On the other hand, if you think you'll spend the rest of your life in your home, then you'll probably want to go for the loan with the lowest APR. Other considerations might also come into play. If you don't have the cash on hand to pay upfront fees or don't wish to raid your investments to get it, then keeping fees down will be a bigger priority than getting the lowest APR.

Nailing it all down

Of course, getting a precise fix on all this is tough. You may know how the APRs on several different loans compare over their entire term, but do you know how much the margin will change if you assume you'll only be in your house for 10 years? Or seven years? Or five?

If you would like to do a more precise comparison, you might check out the True Cost Calculator at the Fannie Mae Homepath.com site. Here, you can plug in your loan's rate, term, fees, plus the length of time you plan to keep the loan, and the calculator will give you the before- and after-tax cost of the loan in annual percentage terms. You can even include fees that aren't in the APR.

Finally, you should know that there's a lot more to the refinancing decision than knowing the difference between a loan's nominal interest rate and its APR. You should also consider issues like how to shop among lenders to assure you're getting the best APR available and long it will take you to recoup the cost of refinancing.