That Sneaky APR

When looking at mortgage rates, what's the difference between the interest rate and the APR?

A loan's annual percentage rate, or APR, is its yearly rate of interest over the lifetime of the loan, including the fees paid to acquire the money. Sounds simple enough, right? But even the experts find themselves befuddled when comparing an advertised mortgage's interest rate with its APR. Thanks to some loopholes in the law, the APR can be calculated in many different ways, allowing the lender to hide all sorts of fees. "Our experience is that the APR causes more confusion than the value that it provides," says Keith Gumbinger, vice president of HSH Associates, a mortgage-tracking firm.

When shopping for a mortgage, everyone knows that one of the most important things to look for is a low interest rate. But the interest rate may be just one component of a loan's total cost. Closing costs and other fees can add as much as 3% to 5% to the total cost of the home. That's where the APR comes in. It's supposed to help consumers understand the true cost of loans. But as President Bush would say, it's fuzzy math.

According to the Truth in Lending Act, lenders are required to include in an APR such costs as points, underwriting fees, private mortgage insurance and prepaid interest. But the advertised APR that you'll find in the newspaper is a completely hypothetical number, warns Gumbinger. It's usually based on a candidate with perfect credit (therefore qualifying for the best terms) who's buying a home very close to the end of the month. This allows the lender to include just one day of prepaid interest in the calculation.

The lender also doesn't need to include fees that aren't charged to everyone, such as the loan-application fee, a credit check, title fees, home inspection, attorney fees and documentation fees. This means a lender could plan to pad, say, the documentation fee in an effort to make more money on the deal and not have the costs show up in the APR.

Adding to the confusion, a lender can round the APR up or down by as much as one-eighth of a percentage point — a sizable difference when you're talking about a 15- or 30-year loan. And when it comes to adjustable-rate mortgages, forget about it. "Most lenders don't know how to do the calculation," HSH Associates' Gumbinger says. Instead, they just use a software program that can, at times, spit out an artificially low number, he explains. Indeed, right now, because short-term Treasury rates are so low (and adjustable mortgages are tied to rates), some advertised APRs for ARMs are actually lower than the interest rate. In the real world, this simply isn't possible.

Rather than focusing on the APR, borrowers should dive into the terms and fees of the mortgage itself, recommends E-Loan Chief Executive Chris Larsen. The most important components are the origination fee, any discount points and the interest rate. Next, consumers should make sure that the rest of the fees are reasonable compared with other lenders. For a listing of closing costs, read our story.

There are, however, times when APRs can be useful. While advertised APRs are typically within a quarter of a point of the interest rate, if the two numbers are drastically different, that can be a red flag. A large gap indicates that the lender is probably charging lots of discount points and other fees that aren't advertised prominently. Each point will add another one-eighth to one-quarter of a point in interest costs. If the spread is more than a half point to three-quarters of a point, be warned, says Gumbinger. That loan might be a lot more expensive than you thought.

For more on buying a home, read our Home-Buying Primer.