What is an Annual Percentage Rate (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 mortgage companies to 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 |
The APR does NOT
affect your monthly payments. Your monthly payments are a function of
the interest rate and the length of the loan.
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, all
you would have to do is compare APRs from the lenders/brokers you are
working with, then 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. Now 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 because 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
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
- Credit report
- Appraisal fee
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 future rates
are unknown. The result is even more confusion 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.
