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How mortgages and APRs work

Once you begin your homebuying journey, it helps to understand how mortgages and annual percentage rates (APRs) work. A mortgage APR reflects the total cost of borrowing and includes costs, like mortgage loan interest, mortgage points and other lender fees. The mortgage loan APR will usually be higher than the interest rate because it includes costs and fees, as well as interest. Knowing how to differentiate between mortgage interest rates and APRs can help you select the best loan for your needs.

What is an APR?

An annual percentage rate (APR) represents the cost of borrowing over the life of the loan expressed as an annual rate. People commonly reference interest rates and APRs when comparing mortgage loans. APRs are typically higher than the interest rate because they include fees associated with getting the loan, like points, origination fees and other charges, as well as interest.

There are two types of mortgage interest rates: Fixed and adjustable. A fixed rate stays the same throughout your loan. A adjustable or variable rate changes with an index such as the prime rate which is based on the Federal Funds Rate outlined by the Federal Reserve Board (FRB). This means that if you get a loan with an adjustable rate, your interest rate could change depending on changes in the index The APR for a variable rate loan estimates how the rate could change over time, but actual changes could be very different.

How does APR work on a mortgage loan?

Understanding how an APR affects your home loan is an important part of the decision-making process. You may choose one option over another based on the APR a lender offers.

When it comes to the APR of a mortgage loan, there is more involved than just interest. Along with interest, the APR can include processing and underwriting fees, mortgage points and private mortgage insurance. The APR determines the total annual cost of borrowing money from a lender. It's important to learn as much as you can about your loan before you accept and sign because APR fees can vary from lender to lender

Interest rate vs. APR

Mortgage interest rates and APRs are usually different amounts. Your interest rate and fees combine to create your APR. Before you sign, your lender must disclose your loan's APR and interest rate to help you understand the overall expenses that make up the total amount you'll be paying.

How will the APR affect my mortgage payment?

Comparing APRs for home loans can help you understand how much you'll be paying over the life of the loan. When you shop for your mortgage, discuss the following details with your lender to ensure you get the best financing deal for your needs:

  • Rates: Request a list of each lender's current mortgage interest rates. Ask whether they're fixed or adjustable rates. If they're adjustable, ask how your loan payment may fluctuate.
  • Points: Ask lenders to quote the points in a dollar amount to clarify what you'll actually be paying. These points are fees paid to the lender for the loan and they help lower the interest rate.
  • Fees: Request a breakdown of charges to understand what each fee includes. If you don't understand certain fees, ask your lender for an explanation.
  • Down payments: Some lenders require 20% of the total home purchase price at closing, while other loan types can require as little as 3% down. Check with your lender for details.
  • Private mortgage insurance (PMI): If you can't put down the full 20%, lenders may require you to get PMI, which increases your monthly mortgage payment.

Having these costs broken down will help you compare quotes properly and identify who's offering the best deal. When you choose the right mortgage, you'll feel secure about your monthly payment and overall budget.

Your lender will provide you with a Loan Estimate which will show loan terms and all of the costs associated with the loan.

What does the mortgage payment include?

Mortgage payments consist of principal and interest. The principal amount is the amount you borrowed. The interest is a specific percentage that you accepted before signing your loan, and this goes directly to the lender. When you make additional principal payments , this reduces the amount of interest you owe.

Mortgage interest rates are fixed or adjustable. While fixed rates remain the same throughout the loan period, an adjustable rate mortgage (ARM) can increase or decrease throughout the length of your loan. When your rate adjusts, your payment changes too. ARMs have rate caps that limit the amount the interest rate can change each year and over the life of the loan. Most ARMs also have an initial fixed rate period before the rate can start to change. For example, homeowners with ARMs might have a fixed rate of 4% for five years, then it may change each year if the index changes..

The rate lenders offer depends on several factors, including:

  • The amount you want to borrow
  • How much you plan to put down on the loan
  • The length of the loan you want
  • Your on-time payment history
  • The type of loan you want
  • Your location

Additional mortgage loan fees

In addition to the mortgage interest rate, the APR includes the costs involved in getting your mortgage loan. Because mortgage interest rates and APRs can differ drastically with the addition of certain fees, it's best to only compare interest rates to interest rates and APRs to APRs. This gives you an accurate picture of what you're getting and helps you pick the best option for your budget and income. Here are some of the fees your APR may include:

  • Loan processing fee
  • Underwriting fee
  • Escrow and settlement fee
  • Document preparation fee
  • Points, origination and discount fee
  • Pre-paid interest
  • Private mortgage insurance
  • Loan application fee

It's best to check with each lender for a breakdown of the costs for their advertised APR. It's also important to note that there may be other fees for securing a home loan that the APR might not cover, such as:

  • Attorney fee
  • Home inspection fee
  • Appraisal fee
  • Title or abstract fee
  • Notary fee
  • Recording fee
  • Transfer taxes

You may need to pay these fees upfront before you close on your loan. As you discuss loan options, ask about the amount of money you'll need to pay before closing.

Breaking down monthly mortgage payments

At the beginning of your mortgage loan, the majority of your payment goes toward interest. As you pay down your mortgage, you'll notice that more money goes toward principal and that your loan amount decreases at a faster rate.

To better understand how much of your payment goes to both interest and principal, study the mortgage amortization schedule for your loan. This document is often included in your closing paperwork, and you can also request it from your lender. Whether you've chosen to do a 15-year or 30-year loan, you'll be able to see how your payments break down every month. You can also see a monthly breakdown of charges on your mortgage statement. Your monthly payment can also include amounts for property taxes, homeowners insurance and private mortgage insurance.

Now that you understand how mortgages and APRs work, you can get ready to approach and compare mortgage lenders with confidence. Remember, it's important to pay attention to the details when comparing mortgage interest rates and APRs. Speak to a Home Lending Advisor for more help understanding the costs associated with your mortgage.

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