Understand the Difference Between Base Rate and APR to Know What You’ll Really Be Paying

The interest rate that you’re being charged on your mortgage obviously has a huge effect on how much you’ll be paying every month. But you’ll probably notice that the base rate of your loan is different from the APR, or annual parentage rate.

Why is that?

Well, not only does the APR rate calculation include the interest rate, but it also takes into account other fees associated with financing the loan. Let’s dig a little deeper to help you understand this crucial difference so that you’ll have a much more accurate number to work with when budgeting for your home.

Your APR Tells You More Than the Base Rate Does

The base interest rate is the percentage of the loan amount that you’re being charged for borrowing money, and is a key number when it comes to comparing loan quotes because it has a direct affect on monthly payments.

On the other hand, the APR rate takes more details into consideration. Basically, the APR will tell you in great detail what the entire cost of your mortgage will be over time, and includes all the lender fees and closing costs that need to be paid out. The extras can include brokerage fees, appraisal costs, processing charges, underwriting expenses, and even title insurance.

Simply put, the base rate is what will be stipulated on your mortgage contract, while the APR is this amount, plus added-on fees as listed above.

This becomes important when you’re shopping around for quotes. That way you can better understand the difference between the interest rate quoted and the fees that need to be paid at closing. Some lenders may charge lower interest rates than others, but then will charge you more in associated lender fees. On the other hand, other lenders may quote a higher rate, but it will cover all the fees associated with closing. Knowing this will help you weigh out which will cost you less in the long run.

Thanks to the Truth in Lending Act, all applicable fees have to legally be disclosed by lenders so consumers can make a sound buying decision when it comes to their mortgages.

APR in Action

Lender fees are basically incorporated into the interest rate which is done by amortizing these fees over the life of the mortgage, then calculating a new interest rate.

Let’s illustrate in more detail how an APR would be calculated. Assume that your quoted interest rate is 4.0%, your mortgage amount is $250,000, and the fees associated with closing are $5,000. This would now mean that you have a $255,000 mortgage ($250,000 + $5,000). This new loan amount is then used to calculate a new monthly payment, which would be $1,341.36 based on a 5-year term and 25-year amortization period.

You would then calculate the APR by working backwards to determine what the interest rate would need to be in order keep the monthly payments the same with the original loan amount ($250,000). When making these calculations in this case, you’d come up with an APR of 4.19%, compared to the 4% with the modified loan amount ($255,000). The APR is generally going to be higher than the base rate because it includes the all the fees associated with your mortgage loan.

Potential Drawbacks of APR

There are certain scenarios where borrowers should probably ignore the APR, including the following:

  • You’ll probably be selling your home within 7 years
  • You’ll probably consider refinancing the mortgage within 7 years
  • You’re shopping around for a home equity line of credit (HELOC)

In these cases, the APR might make certain loans look better than they actually are. Considering the above scenarios, if you only kept the loan for 5 years, the second loan would be a lot pricier, even with a lower APR. That’s because the extra $5,000 in fees are paid upfront, while the first loan’s higher interest rate is amortized over the entire life of the mortgage.

The APR is most ideal if you’re shopping for an adjustable rate mortgage, and expect to hang on to your loan for a long time without looking to refinance or switch over to a HELOC.

At the end of the day, it all depends on your specific situation when it comes to determining whether or not calculating the APR is most useful for you. Chat with your mortgage specialist to determine the best way for you to accurately compare and contrast loan rates among different lenders so you ultimately get the best deal possible.