Image: www.401kcalculator.org
When you apply for a mortgage, your lender will probably quote you an interest rate -- say, 4.5%. The problem with the interest rate is that is doesn't usually reflect the true cost of borrowing money, as mortgages can come with up-front fees and costs, particularly discount points. To compare the true cost of a mortgage loan, it's helpful to determine its effective interest rate, which is also referred to as the annual percentage rate, or APR.
How to calculate the effective interest rate, or APR
The calculation of APR involves a rather complex mathematical formula, but there is a relatively easy "shortcut" method you can use that involves a little bit of trial and error.
- Open a mortgage calculator like this one from Bankrate .
- Add up your discount points, origination fees, and other up-front costs like mortgage insurance premiums (Note: closing costs are not included).
- Add this amount to the loan amount.
- Using the mortgage calculator, input this adjusted loan amount, along with your loan's stated interest rate, in order to determine your adjusted monthly payment.
- Finally, using the mortgage calculator, input the original loan amount and find the interest rate that corresponds with the adjusted monthly payment. This is your loan's effective interest rate, or APR.
An example
Let's say your lender offers you a $200,000 mortgage at 4% interest. The lender charges one discount point ($2,000) and an origination fee of $750, making the total up-front cost $2,750.
Adding this to the loan amount gives us $202,750, which at 4% interest would produce a monthly payment of $968. Changing the loan amount in the calculator back to $200,000, and trying out a few interest rates, shows that an interest rate of 4.11% would produce that same $968 monthly payment. Therefore this loan's effective interest rate, or APR, is 4.11%.
APR can vary significantly, so be sure to compare the right number
Fortunately, you probably won't have to go through this process when you're shopping for a home loan. Lenders must disclose the APR within three days of receiving the borrower's application, and it cannot change by more than one-eighth of a percent before settlement without the borrower's knowledge.
So, when you go shopping for a mortgage, be sure you're taking the true cost of borrowing into account and not just the interest rate, which doesn't tell you anything about the fees and other up-front expenses you'll have to pay.
The $15,978 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. In fact, one MarketWatch reporter argues that if more Americans knew about this, the government would have to shell out an extra $10 billion annually. For example: one easy, 17-minute trick could pay you as much as $15,978 more... each year! Once you learn how to take advantage of all these loopholes, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how you can take advantage of these strategies.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in theFoolsaurus. Pop on over there to learn more about our Wiki andhow you can be involvedin helping the world invest, better! If you see any issues with this page, please email us atknowledgecenter@fool.com. Thanks -- and Fool on!
The article How to Calculate the Effective Interest Rate Including Discount Points originally appeared on Fool.com.
The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .
Copyright © 1995 - 2016 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
