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.
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
calculators to calculate
your monthly payments as well as your APR.
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:
- Pointsboth 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 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!
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.