Understanding
APR
The annual percentage
rate (APR) is an interest rate that is different from the
note rate. It is commonly used to compare loan programs from
different lenders. The Federal Truth in Lending law requires
that mortgage companies disclose the APR when they advertise
a rate. Typically the APR is found next to the rate.
Example:
| 30-year fixed |
8% |
1 point |
8.107% APR |
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The APR does NOT
affect your monthly payments. Your monthly payments are a
function of the interest rate and the length of the loan.
We provide a calculator
to calculate your monthly payments as well how much you may
be approved for.
The APR is a very confusing
number! Even mortgage bankers and brokers admit it is confusing.
The APR is designed to measure the "true cost of a loan."
It creates a level playing field for lenders. It prevents
lenders from advertising a low rate and hiding fees.
If life were easy, then
all you would have to do is compare APRs from the lenders/brokers
you are working with, pick the easiest one, and you would
have the right loan. Right? Wrong!
Unfortunately, different
lenders calculate APRs differently! So a loan with a lower
APR is not necessarily a better rate. The best way to compare
loans in the author's opinion is to ask lenders to provide
you with a good-faith estimate of their costs on the same
type of program (e.g. 30-year fixed) at the same interest
rate. Then, delete all fees that are independent of the loan
such as homeowners insurance, title fees, escrow fees, attorney
fees, etc. Add up all the loan fees. The lender that has lower
loan fees has a cheaper loan than the lender with higher loan
fees.
The reason why APRs
are confusing is that the rules to compute APR are not clearly
defined.
What fees are included
in the APR?
The following fees ARE
generally included in the APR:
- Points––both discount points
and origination points.
- Pre-paid interest. The interest paid
from the date the loan closes to the end of the month.
Most mortgage companies assume 15 days of interest in
their calculations. However, companies may use any number
between 1 and 30!
- Loan-processing fee.
- Underwriting fee.
- Document-preparation fee.
- Private mortgage insurance.
- Appraisal fee.
- Credit-report fee.
The following fees are
SOMETIMES included in the APR:
- Loan-application fee.
- Credit life insurance (insurance
that pays off the mortgage in the event of a borrowers
death).
The following fees are
normally NOT included in the APR:
- Title or abstract fee.
- Escrow fee.
- Attorney fee.
- Notary fee.
- Document preparation (charged by
the closing agent).
- Home inspection fees.
- Recording fee.
- Transfer taxes.
An APR does not tell you
how long your rate is locked for. A lender who offers you
a 10-day rate lock may have a lower APR than a lender who
offers you a 60-day rate lock!
Calculating APRs on adjustable
and balloon loans is even more complex, because the future
rates are unknown. The result is even more confusing about
how lenders calculate APRs.
Do not attempt to compare
a 30-year loan with a 15-year loan using their respective
APRs. A 15-year loan may have a lower interest rate, but could
have a higher APR, since the loan fees are amortized over
a shorter period of time.
Finally, many lenders
do not even know what they include in their APR because they
use software programs to compute their APRs. It is quite possible
that the same lender with the same fees using two different
software programs may arrive at two different APRs!
Conclusion:
Use the APR as a starting point to compare loans. The APR
is a result of a complex calculation and not clearly defined.
There is no substitute to getting a good-faith estimate from
each lender to compare costs. Remember to exclude those costs
that are independent of the loan.
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