APR Vs. APY: Understanding Mortgage Rates

Several factors can affect the overall price of your home. These factors may include closing costs, legal fees and the interest rate you get on your mortgage. Also, there are different types of interest rates that can affect your cost of borrowing, including annual percentage rates (APR) and annual percentage yields (APY). If you’re wondering what the difference is between APR versus APY mortgage rates and how they affect your total cost of homeownership, keep reading.

Understanding Your Interest Rates

An interest rate is a cost that financial institutions charge a borrower when they borrow money. The amount of interest a person is charged depends on their credit score, the loan amount and more. The lower the interest rate on a mortgage, the lower the amount the borrower will owe on the home over time.

What Is The Difference Between APR And APY?

APR, or annual percentage rate, is a more accurate indicator of how much a loan will cost because it includes the lender’s origination fees. However, it is only accurate for loans based on simple interest. For loans with compounding interest, APY is a more accurate indicator of a loan's total cost.

APY, or annual percentage yield, is a more accurate measure of the yearly cost of a loan than APR. It is most applicable in situations where interest compounds daily or monthly, such as credit card debt.

What Is Annual Percentage Rate (APR)?

APR is a combination of the interest and fees that lenders charge for originating a loan. It includes the interest rate, points, fees and insurance on a mortgage.

When shopping for a loan, home buyers do not have to do the math on their APR alone, nor do they have to look far for it. The Truth in Lending Act of 1968 states that lenders must provide people with a disclosure statement that includes the APR of a loan. It must also include any charges, a list of scheduled payments and the total dollar cost it will take to repay a loan if the mortgage is held until the end of its term.

Home buyers should ask their prospective mortgagors about the APR on their loan.

What Is Annual Percentage Yield (APY)?

APY is the measure of the yearly cost of a loan, including interest compounded. In most cases, APY will be higher than the APR, depending on the compounding period. If a loan only compounds once per year, the APR and APY will be the same. You may be most familiar with compound interest if you hold a savings account or deposit account with favorable APY.

Why Compound Interest Matters

Compounding interest is calculated on the initial principal of a loan and the accumulated interest of prior months. If interest compounds monthly, this means that the first month of a loan's origination accrues interest. The second month accrues interest both on a loan's principal and its interest in the first month. This trend continues throughout the life of a loan and is most common in credit cards.

Therefore, the inclusion of compound interest in APY can have significant implications for borrowing and investing.

Mortgage APR Vs APY In Practice

When shopping for mortgages, you must interpret both APR and APY. As a borrower, you should always search for the lowest possible rate on your mortgage. Although quoted rates from a mortgagor may seem low, you could end up paying more than you initially expected if you do not understand the APR and APY on your loan.

A Mortgage Example

Let’s say that you take out a $100,000 mortgage at 3.99% interest compounded quarterly. Quarterly means that your loan will be charged a quarter of the interest for the year, or about .9975% interest. At the beginning of the year, your loan would have a balance of $100,000. After the first quarter, it will be charged .9975% interest, or $997.50.

In real life, you’d be making monthly payments over the quarter that decrease the balance of your loan. However, for this example, let’s assume you are not making payments.

As you can see, a .9975% interest against the new quarterly balance of $100,997.50 will be greater, increasing the balance of the loan to $102,004.95. Over a year, the balance of this loan would grow to $104,050.10.

This means that the cost of borrowing for that year would be $4,050.10 in interest or 4.05% of the loan's total balance. The APR on this loan was 3.99%. The APY on this loan is 4.05%.

Therefore, compounding interest increased the total cost of a loan, creating a new effective interest rate. It is essential to calculate APY over the course of your loan term and compare APY across all your loan options before taking out a mortgage loan.

Interpreting What Rates Mean

When doing your homework before you take out a mortgage, it’s essential to know that APR and APY might be used in different situations to reflect the amount of savings or debt that you are taking on.

For this reason, you should always get both the APR and the APY on paper before you sign a mortgage document. When you understand all the figures that go into your mortgage, you will be better equipped to make your monthly mortgage payments and be financially successful.

APR And APY Tips For Home Buyers

When buying a home, there are several things you should be aware of regarding APR and APY. These include:

Compare Rates And Find A Lender You Trust

One way to ensure you get the best rates on your mortgage is to shop around for a lender.  The right lender will not only have reasonable rates but will be able to answer any questions you have about the mortgage process. Feel free to speak to one of our Home Loan Experts.

Use A Calculator

You can use a mortgage loan calculator to help you get a better idea of how much you can afford per month. Calculators can also help you see if making extra payments on your mortgage or larger down payment will save you more money in the long run.

The Bottom Line: Look Beyond The Interest Rate

Don’t take interest rates at face value. The loan option with the lowest interest rate may seem attractive, but it’s important to look at the bigger picture.

Another tool that offers a more expansive view of the cost of a loan is an amortization table, which allows you to view all your scheduled monthly payments, broken down by interest and principal, over the life of the loan.