The term "APR" is supposed to give consumers an easy way to compare loan offers, but if you use it as your only method of comparison you'll probably end up with the wrong loan. Confusing? Let's back up.
The Federal Truth in Lending Act requires lenders to disclose the APR - annual percentage rate - on every loan so consumers can have a single number to use in comparing loan offers. APR is computed by including the rate of interest on the amount borrowed plus the amount of the fees you have to pay to get that loan. The higher the APR, the more you will pay over the life of the loan. It shows the total cost of the credit extended to you, expressed as a percentage of the amount of credit.
The true interest rate you pay on your loan is called the "nominal" or "stated" or "headline" rate. If there are no fees charged, the APR and the note rate are the same. Adding in the fees makes the APR - also known as the "effective" rate - higher. Comparing APRs is better than comparing the stated rates because the stated rates do not take into account fees and points. And while it's a good starting point for an impromptu comparison of lenders, it does not represent the total cost of borrowing or really create a standard for comparing loans.
The main area in which APR fails borrowers is the way it takes upfront and lump-sum costs into consideration. One of these costs is points. Many buyers agree to pay lenders a certain percentage of the amount of the loan in exchange for a lower interest rate. While such an arrangement may mean the difference between, for example, a 6.5% interest rate and 5.5% rate, it may or may not be the most cost-effective thing to do depending on the borrower's plans for the new house. In this example, the lower interest rate only makes sense if you hold on to your mortgage long enough to recover that upfront cost through cumulative interest savings. But the typical borrower refinances or sells their home long before the 15 or 30-year mortgage comes full term. According to the Federal Home Loan Mortgage Corp., better known as Freddie Mac, the typical buyer holds a mortgage for fewer than five years - rarely enough time to recover the thousands of dollars in prepaid interest.
APR doesn't take that into account. APR will always show that the low-rate, high point combination would be the best deal. Really, the only people who should use APR are people who plan to stay in their homes for 15 to 30 years. If you have a shorter time horizon, don't base your borrowing decision solely on APR.