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Mortgage

APR vs Interest Rate: Understanding the Difference

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

It’s common for homebuyers to focus on interest rates while shopping for a mortgage, however, there’s another number that might even be more important.

While a low interest rate is appealing and directly impacts your monthly mortgage payment, it’s also important to look at each loan’s annual percentage rate, which provides a clearer picture of how much the loan will cost you when other fees are factored in.

The APR includes the interest rate as well as other fees and costs, and is expressed as a percentage. The interest rate only includes interest paid to the bank.

The difference between mortgage APRs and interest rates

An annual percentage rate (APR) is a broad measure of what it costs to borrow a loan. It includes the interest rate as well as other fees and costs.

The difference between an APR and an interest rate is that an APR gives borrowers a truer picture of how much the loan will cost them. Although an APR is expressed as rate just like interest, it is not related to your monthly payment — which is calculated using only the interest rate. Instead, an APR reflects the interest rate along with fees and other one-time costs a borrower will pay to get a mortgage.

“You can find a mortgage that has a 4% interest rate, but with a bunch of fees, that APR may be 4.6% or 4.7%,” said Todd Nelson, senior vice president of strategic partnership with online lender LightStream. “With all of those fees baked in, they are going to swing the interest rate.”

For example, one lender may charge no fees, so the loan’s APR and interest rate are essentially the same. The second lender may charge a 5% origination fee, which will increase the APR on that loan.

How APRs impact mortgages

Lenders calculate an APR by adding fees and costs to the mortgage interest rate and creating a new price for the loan. Let’s look at an example:

A lender approves a $100,000 mortgage at a 4.5% interest rate. The borrower decided to buy one discount point, which costs $1,000, to get the 4.5% rate (a discount point is a fee paid to the lender in exchange for a reduced interest rate). The loan also includes $900 in fees, which are being financed in the mortgage.

With the fees and costs mentioned above added to the loan, the adjusted starting mortgage balance becomes $101,900. The monthly payment (which consists of the principal plus interest) is then $516.31 with the 4.5% interest rate, compared with $506.69 if the balance had remained at $100,000.

To find the APR, the lender returns to the original loan amount of $100,000 and calculates the interest rate that would create a monthly payment of $516.31. In this example, that APR would be approximately 4.661%.

APRs will vary between lenders, as no two lenders are exactly alike. Some may offer competitive interest rates, but then tack on expensive fees and costs. Lenders with the same interest rate and APR probably aren’t charging any fees on that loan, and lenders that offer APR and interest rates that are close are likely charging a lower amount of fees and extra costs.

In short, APR gives you a way to compare two lenders offering the same interest rate so you make the smartest possible decision about your mortgage.

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What factors influence an APR?

APRs change as interest rates fluctuate, but they’re more impacted by lender costs and fees. Below are some of the common charges that affect APRs:

  • Discount points: Lenders allow buyers to purchase points in return for a lower interest rate. The cost of a point is equal to 1% of the mortgage amount and typically lowers the interest rate on the loan by an eighth of a percentage point. For example, a buyer approved for a $100,000 loan could buy three points, at $1,000 each, to lower the interest rate from 4.5 to 4.125.
  • Loan origination fees: Loan origination fees typically average about 1% of the loan amount. This cost can be especially significant for larger loans.
  • Loan processing: This fee, which some lenders will negotiate, pays for the cost of processing a mortgage application.
  • Underwriting: These fees cover an underwriter’s review of a loan application, including the borrower’s income, credit history, assets and liabilities and property appraisal, to determine whether the lender should approve the loan application and what terms should be applied to the loan.
  • Appraisal review: Some lenders pay an outside reviewer to make sure an appraisal meets underwriting standards and that the appraiser has submitted an accurate report of the home’s value.
  • Document drawing: Lenders often charge a fee for creating mortgage documents for a loan.

Closing costs that aren’t commonly in an APR calculation are notary fees, credit report costs, title insurance and escrow services, home appraisal, home inspection, attorney fees, document preparation and recording fees.

Because an APR includes a loan’s interest rate, rising interest rates will increase the APR for several products including mortgages, auto loans and other types of loans and credit.

How interest rates affect mortgages

A mortgage interest rate is the rate a lender uses to determine how much to charge a homebuyer for borrowing money. Mortgage rates can either be fixed or adjustable.

Fixed mortgage rates don’t change over the life of a loan. For example, if you take out a 30-year loan at a 4.25% interest rate, that rate will stay the same — regardless of changes in the economy and market index — until the loan is paid off.

On the other hand, adjustable-rate mortgages (ARMs) will fluctuate as market conditions change after an introductory period, often set at five or seven years. That means your interest rate could go up or down depending on the economy, which will in turn raise or lower your mortgage payments.

ARMs often start with a lower interest rate than a fixed-rate mortgage, but can dramatically increase after the intro period ends.

If you are considering an ARM, it’s important to talk to lenders first about what an adjustable rate could mean for your monthly mortgage payments. Be sure to ask the following questions:

  • How long is the introductory fixed-rate period?
  • How often does the interest rate adjust after the fixed-rate period ends?
  • How does this loan compare to fixed-rate mortgage options?
  • How much will the monthly payment and interest rate increase with each adjustment?
  • What is the cap on how high or low the interest rate can go?
  • Is the monthly payment still affordable if the interest rate reaches the maximum allowed under the loan contract?

What factors influence an interest rate?

Don’t be surprised if a lender’s mortgage rate is higher than what was advertised. Each loan’s interest rate is primarily determined by market conditions and by the borrower’s financial health. There are several factors that help determine your rate, including:

  • Your credit score: Borrowers with higher credit scores generally receive better interest rates.
  • Your down payment: Lenders may offer a lower rate to borrowers who can make a larger down payment, which often is an indicator that the borrower is financially secure and more likely to pay back the loan.
  • The loan term: The number of months you agree to pay back the loan can make a difference. Generally, a shorter-term loan will have a lower rate than a longer-term loan — but higher monthly payments.
  • The loan amount: Interest rates can be different for loan amounts that are unusually large or small.
  • The loan type: While many borrowers apply for conventional mortgages, the federal government offers loan programs through the FHA, USDA and VA that may have lower interest rates.
  • The location of the property: Interest rates are different in rural and urban areas, and can also vary by county.

Below, we use MagnifyMoney’s mortgage calculator to illustrate how interest rates can affect monthly mortgage payments.

Loan amount$250,000 $250,000
Interest rate3.84% 4.20%
Monthly payment
(Principal and interest)
$1,170.59 $1,222.54
Interest paid after five years$8,651.39 $9,517.96

As shown above, an interest rate increase of even less than a half-percent could bump your monthly payment up by nearly $52, and your interest paid over the first five years by more than $800.

Mortgage comparison-shopping tips

When you’re shopping for a mortgage, it’s wise to gather quotes from multiple lenders to ensure you find the best mortgage terms available. It’s also important to get those mortgage quotes on the same day and around the same time.

Online marketplaces such as LendingTree can provide real-time loan offers from multiple lenders, which makes it easier to compare mortgage APRs and interest rates.

If a loan’s APR matches its interest rate, you likely have a good deal. Otherwise, investigate the costs and fees behind a quoted APR to determine which mortgage offer is the best deal. The most effective way to do so is by comparing the Loan Estimate documents you receive from each lender after submitting a mortgage application.

Recent research underscores the significance of shopping around. Homebuyers could realize a potential interest savings of nearly $50,000 over the life of a 30-year, fixed-rate $300,000 loan by comparison shopping for the best APR.

Lastly, once you’ve found the best rate, ask your lender about your rate lock options.

What about APRs on ARMs?

The annual percentage rate on an adjustable-rate mortgage won’t apply for the life of the loan, since the interest rate and monthly payment will change as the economy fluctuates. The APR only applies during the loan’s initial fixed-rate period, and no one can predict how much the rate will increase in the years that follow.

For example, a 7/1 ARM has a fixed interest rate for the first seven years that is determined by the market conditions on the day the loan was closed. After seven years, the interest rate will adjust annually, based on the movement of the index the ARM is tied to, which is commonly the one-year LIBOR.

The new rate likely won’t be the same as it was when the loan was originated. Mortgage rates fluctuate daily, and no economic forecaster can accurately predict how the index will change in the future.

The bottom line

While lenders often push their low interest rates when they advertise loans, Nelson said it’s vital that consumers check APRs when shopping around, and pay attention to how loan advertisements are worded. Lenders may advertise “no hidden fees,” he said, but that might just mean there are other fees that simply aren’t hidden.

“Look for a lender that’s transparent about disclosing all of those fees,” Nelson said.

Ask for clarity about any cost estimates you don’t understand, and try to negotiate lender fees where possible.

This article contains links to LendingTree, our parent company.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Marty Minchin
Marty Minchin |

Marty Minchin is a writer at MagnifyMoney. You can email Marty here

Crissinda Ponder
Crissinda Ponder |

Crissinda Ponder is a writer at MagnifyMoney. You can email Crissinda here

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Mortgage

Should You Save for Retirement or Pay Down Your Mortgage?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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On the list of financial priorities, which comes first — paying off your mortgage or saving for retirement? The answer isn’t simple. On one hand, owning a home with no mortgage attached to it provides long term security knowing you’ll have a place to live with no monthly payment except property taxes and insurance. However, you’ll also need income to live on if you plan to retire, and how much you save now will have a big impact on your quality of retirement life.

We’ll discuss the pros and cons of whether you should save for retirement or pay down your mortgage, or maybe a combination of both.

Pros of paying down your mortgage vs. saving for retirement

The faster you pay your mortgage off, the sooner you own the home outright. However, there are other benefits you’ll realize if you take extra measures to pay your loan balance off faster.

You could save thousands in long-term interest charges

Most homeowners take out a 30-year mortgage to keep their monthly payments as low as possible. The price for that affordable payment is a big bill for interest charged over the 360 payments you’ll make if you’re in your “forever” home.

For example, a 30-year fixed $200,000 loan at 4.375% comes with a lifetime interest charge of $159,485.39. That’s if you never pay a penny more than your fixed mortgage payment for that 30-year period. Using additional funds to pay down your mortgage faster can significantly reduce this.

Even one extra payment a year results in $27,216.79 in interest savings on the loan we mentioned above. An added bonus is that you’ll be able to throw your mortgage-free party four years and five months sooner.

You’ll build equity much faster

Thanks to a beautiful thing called amortization, lenders make sure the majority of your monthly mortgage payment goes toward interest rather than principal in the beginning of your loan term. Because of that, it’s difficult to make a real dent in your loan principal for many years. You can, however, counteract this by making additional payments on your mortgage and telling the lender to specifically put those payments toward your principal balance instead of interest.

Not only do you pay less interest over the long haul with this strategy, but you build the amount of equity you have in your home much faster. And to homeowners, equity is gold — you’re closer to owning your home outright, and equity can also be a resource if you need funds for a home improvement project or another big expense.

You can access that equity as your financial needs change by doing a cash-out refinance or by taking out a home equity loan or home equity line of credit (HEL or HELOC).

You won’t lose your home if values drop

When you contribute extra money into a retirement account, there is always the risk that you’ll lose some or all of the money you invested. When you contribute money to paying off your mortgage, even if the values drop, you still have the security of a place to live, and are increasing the equity in the home, no matter how much it’s ultimately worth.

Making extra payments ensures you’ll eventually have a debt-free asset that provides shelter to you and your family, regardless of what happens to the housing market in your neighborhood.

Cons of paying down your mortgage vs. saving for retirement

There are some cases where paying down your mortgage faster might actually hurt you financially. Before adding extra principal to your mortgage payments, you’ll want to make sure you aren’t doing damage to your financial outlook with an extra contribution toward your mortgage payoff.

You might end up paying more in taxes

The higher interest payments you make during the early years of your mortgage can act as a tax benefit, so paying the balance down faster could actually result in you owning more in federal taxes. If you are in a higher tax bracket in the early (first 10 years) of your mortgage repayment schedule, it may make sense to focus extra funds on retirement savings, and let your mortgage interest deduction work for you. Of course, everyone’s tax situation is different, so you’ll have to decide (with help from an accountant ideally) if it makes sense to itemize your taxes in order to claim mortgage interest payments as a deduction.

You won’t get to enjoy the return on your paydown dollars until you sell

The only real benchmark for figuring out the value of paying down your mortgage is to look at how much equity you’re gaining over time. However, the equity doesn’t become a tangible profit until you actually sell your home. And the costs of a sale can take a big bite out of your equity because sellers usually pay the real estate agent fees.

Home equity is harder to access

The only way to access the equity you’ve built up is to borrow against it, or sell your home. Borrowing against equity often requires proof of income, assets and credit to confirm you meet the approval requirements for each equity loan option. If you fall on hard financial times due to a job loss, or are unable to pay your bills and your credit scores drop substantially, you may not be able to access your equity.

Pros of saving for retirement vs. paying down your mortgage

Depending on your financial situation and savings habits, it may be better to add extra funds monthly to your retirement account than to pay down your mortgage. Here are a few reasons why.

You may earn a higher return on dollars invested in retirement funds

The growth rate for a stock portfolio has consistently returned more than housing price returns. The average return in the benchmark S&P stock fund is 6.595% for funds invested from the beginning of 1900 to present, while home values have increased just 0.1% per year after accounting for inflation during that same time period.

Assuming your portfolio at least earns 7%, if you consistently invest your money into a balanced investment portfolio, you can expect to double your money every 10 years. There aren’t many housing markets that can promise that kind of growth.

Retirement funds are generally easier to access than home equity

Retirement funds often give you a variety of options for each access, with no income or credit verification requirements, and only sufficient proof of enough funds in your account to pay it back over time. For example, a 401k loan through the company you work for will just require you to have enough vested to support the loan request, and sufficient funds left over to pay it off over a reasonable time.

Just be cautious about making a 401k withdrawal, which is treated totally differently than a loan. You aren’t expected to pay it back like you would a 401k loan, but you could get hit with taxes and penalties.

Cons of saving for retirement vs. paying down your mortgage

You’ll need to weather the ups and downs of the market

Most people who have invested money in the stock market or tracked the performance of their 401k over decades have stories about periods when the value of those investments dropped substantially. While the 7% return on investment is a reliable long term indicator how much your retirement fund might earn, the path to that return is hardly linear.

For example, if you were considering retirement between 1999 and 2002, you may have had to delay those plans when the S & P plummeted over 23% in value in 2002. If you look at each 10-year period since the 1930s, every decade has been characterized by periods of ups and downs.

Calculating the benefit of paying down your mortgage vs. saving for retirement

If you’re torn as to what to do with that extra cash or windfall, let’s look at an example of someone who has an extra $200 to put into either their nest egg or their mortgage each month for the next 30 years.

For this scenario, we’re going to assume their retirement account earns an average 7% rate of return and that their mortgage loan balance is $200,000.

Here’s how much they’d save:

Savings From Paying $200 per Month Down on Your Mortgage
Years PaidMortgage Interest SavingsExtra Equity in HomeTotal Interest Savings and Equity Built Up
10 years$6,040$30,039$36,079
20 years$28,529$76,529$105,058
22 years 6 months$50,745$200,000$250,745

One thing you may notice about the mortgage savings chart — it includes how much extra equity you’re building. Often only the mortgage interest savings is cited when people look at how much you save with extra payments, but that ignores the fact that you’re building equity in your home much faster as well. So not only do you save over $50,000 in interest with your extra contribution, you replenish $150,000 of equity that was used up by your mortgage balance.

As you can see, adding that extra $200 to their mortgage principal each month saved them about $200,000 in the long haul — but the real savings don’t stop there.

By adding an extra $200 to their mortgage payment each month, this borrower turned their 30-year loan into a 22-and-a-half year loan and became mortgage debt-free seven years faster.

That means, in addition to saving $50,000 in interest savings and gaining $200,000 of equity, they also no longer have a mortgage payment. That frees up $998.57 per month that they can now use as discretionary income. That’s an extra $89,871 they could potentially save over that 7.5 year period.

When you add that to the $250,745.41 they saved on mortgage interest and earned in home equity, they’re looking at a total savings of $340,616.

That gives the mortgage paydown a $54,000 net positive edge over saving that extra $200 for retirement, as you can see in the table below.

Savings From Contributing $200 per Month to a Retirement Fund
Years PaidRetirement Balance
10 years$34,404
20 years$102,081
30 years$235,212

The one caveat for this retirement calculation is we assumed the saver was starting at a $0 investment balance. If they already had a healthy balance in their nest egg, they might actually come out in better shape than paying down their mortgage.

There are clearly benefits to each option, and you should consider running your own calculations with your real numbers to get the best answer for yourself.

Paying down your mortgage and saving for retirement at the same time

There’s a fair case to be made for both paying down your mortgage and saving more for retirement, but why choose? If you’re somewhat on track with your retirement savings goals, and like the idea of having your mortgage paid off quicker, you could allocate a certain amount to each.

Pick a number you feel comfortable paying to your principal every month, and then to your 401k, and put it on autopilot for a year. Any time your income increases, or you get bonuses, divide up the amount between principal pay down and retirement additions.

Let’s look at what happens if you evenly divide up your $200 per month between investing your retirement and paying down your mortgage. We’ll use the same $200,000 loan at 4.375% referenced above, and look at the lifetime results.

Savings From Paying $100 Down on Your Mortgage Until Paid Off
Years PaidInterest SavingsExtra Home EquityTotal Interest Savings and Equity Built Up
10 years$3,020$15,020$18,040
20 years$14,265$38,265$52,350
25 years$30,534$200,000$230,534
Savings From Contributing $100 to a Retirement Fund for 30 Years
Years PaidRetirement Balance
10 years$17,202
20 years$51,401
30 years$117,607

Balancing the $100 investment in both strategies still yields a six-figure retirement balance after 30 decades, a debt-free house after 26 years, and shaves off $30,000 in mortgage interest expense. If you don’t like putting all your eggs into one financial basket, this may balance the risks and rewards of each option.

Final thoughts

Looking at the short term and the long term may provide you with the best framework for making a good decision about how to spend dollars on retirement versus extra mortgage payments. Be wary of any financial professional that tells you one path is absolutely better than another.

Having a stable source of affordable shelter is equally as important as having enough income to live when you retire, so a balanced approach to paying down your mortgage and savings for retirement may help you accomplish both goals.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Denny Ceizyk
Denny Ceizyk |

Denny Ceizyk is a writer at MagnifyMoney. You can email Denny here

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Life Events, Mortgage

What Is Mortgage Amortization?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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One of the biggest advantages of homeownership versus renting is each mortgage payment gradually pays off your mortgage and builds equity in your home. The difference between your home’s value and the balance of your loan is home equity, and your equity grows with each payment because of mortgage amortization.

Understanding mortgage amortization can help you set financial goals to pay off your home faster or evaluate whether you should refinance.

What is mortgage amortization?

Mortgage amortization is the process of paying off your loan balance in equal installments over a set period. The interest you pay is based on the balance of your loan (your principal). When you begin your payment schedule, you pay much more interest than principal.

As time goes on, you eventually pay more principal than interest — until your loan is paid off.

How mortgage amortization works

Understanding mortgage amortization starts with how monthly mortgage payments are applied each month to the principal and interest owed on your mortgage. There are two calculations that occur every month.

The first involves how much interest you’ll need to pay. This is based on the amount you borrowed when you took out your loan. It is adjusted each month as your balance drops from the payments you make.

The second calculation is how much principal you are paying. It is based on the interest rate you locked in and agreed to repay over a set period (the most popular being 30 years).

If you’re a math whiz, here’s how the formula looks before you start inputting numbers.

Fortunately, mortgage calculators do all the heavy mathematical lifting for you. The graphic below shows the difference between the first year and 15th year of principal and interest payments on a 30-year fixed loan of $200,000 at a rate of 4.375%.

For the first year, the amount of interest that is paid is more than double the principal, slowly dropping as the principal balance drops. However, by the 15th year, principal payments outpace interest, and you start building equity at a much more rapid pace.

How understanding mortgage amortization can help financially

An important aspect of mortgage amortization is that you can change the total amount of interest you pay — or how fast you pay down the balance — by making extra payments over the life of the loan or refinancing to a lower rate or term. You aren’t obligated to follow the 30-year schedule laid out in your amortization schedule.

Here are some financial objectives, using LendingTree mortgage calculators, that you can accomplish with mortgage amortization. (Note that MagnifyMoney is owned by LendingTree.)

Lower rate can save thousands in interest

If mortgage rates have dropped since you purchased your home, you might consider refinancing. Some financial advisors may recommend refinancing only if you can save 1% on your rate. However, this may not be good advice if you plan on staying in your home for a long time. The example below shows the monthly savings from 5% to 4.5% on a $200,000, 30-year fixed loan, assuming you closed on your current loan in January 2019.

Assuming you took out the mortgage in January 2019 at 5%, refinancing to a rate of 4.5% only saves $69 a month. However, over 30 years, the total savings is $68,364 in interest. If you’re living in your forever home, that half-percent savings adds up significantly.

Extra payment can help build equity, pay off loan faster

The amount of interest you pay every month on a loan is a direct result of your loan balance. If you reduce your loan balance with even one extra lump-sum payment in a given month, you’ll reduce the long-term interest. The graphic below shows how much you’d save by paying an extra $50 a month on a $200,000 30-year fixed loan with an interest rate of 4.375%.

Amortization schedule tells when PMI will drop off

If you weren’t able to make a 20% down payment when you purchased your home, you may be paying mortgage insurance. Mortgage insurance protects a lender against losses if you default, and private mortgage insurance (PMI) is the most common type.

PMI automatically drops off once your total loan divided by your property’s value (also known as your loan-to-value ratio, or LTV) reaches 78%. You can multiply the price you paid for your home by 0.78 to determine where your loan balance would need to be for PMI to be canceled.

Find the balance on your amortization schedule and you’ll know when your monthly payment will drop as a result of the PMI cancellation.

Pinpoint when adjustable-rate-mortgage payment will rise

Adjustable-rate mortgages (ARMs) are a great tool to save money for a set period as long as you have a strategy to refinance or sell the home before the initial fixed period ends. However, sometimes life happens and you end up staying in a home longer than expected.

Knowing when and how much your payments could potentially increase, as well as how much extra interest you’ll be paying if the rate does increase, can help you weigh whether you really want to take a risk on an ARM loan.

The bottom line

Mortgage amortization may be a topic that you don’t talk about much before you get a mortgage, but it’s certainly worth exploring more once you become a homeowner.

The benefits of understanding how extra payments or a lower rate can save you money — both in the short term and over the life of your loan — will help you take advantage of opportunities to pay off your loan faster, save on interest charges and build equity in your home.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Denny Ceizyk
Denny Ceizyk |

Denny Ceizyk is a writer at MagnifyMoney. You can email Denny here

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