Annual Percentage Rate (APR)
APR is a confusing construct for many people. Most realtors, and I dare say many mortgage brokers, do not truly understand it, even thought its professed purpose is to clarify. The APR was designed to allow borrowers to compare the various interest rates of different loans and the costs associated with obtaining those loans. The APR is a measure of the total cost of a loan transaction expressed as a yearly interest rate.
It’s often not easy to choose between a loan with a lower rate and higher fees and a loan with a higher rate and lower fees. For example, which lender is offering the better deal, Lender A with a loan of $100,000 at 8% with $3000 in fees or Lender B at 8.25% with no fees. On a 30-year note the payment with Lender A would be $733.76/month and with Lender B the payment would be $751.27/month. So, it looks like Lender A with both the lower interest rate and smaller payment would be the clear-cut winner. But when one takes the $3000 of lender fees (application fees, underwriting costs, points, etc.) into account on an annualized basis along with the payments one discovers that Lender B’s program is the better deal because the APR is 8.25% vs. Lender A’s 8.32%. (I have simplified the example here for purposes of illustration. There would undoubtedly be some fees with the Lender B). Thus, one can see that this may be a useful tool for comparing similar loan programs. In order to help borrowers make a more informed decision on their mortgage federal law mandates that the APR be disclosed along side the actual interest rate.
Note: Comparing APR’s only works when comparing similar loan programs like a mortgage with a 15-year term with another one with a 15-year term or fixed rate loan with another fixed rate loan. Fifteen-year terms will have lower APRs because of their lower interest rates, but higher fees than a 30-year term because they are spread out over fewer years. ARM loans are apt to have lower interest rates than fixed rate loans but possibly more in fees.
In part, the reason why APRs are confusing is because the rules to compute APR are not clearly defined. APR is based on a rather complex mathematical formula. It reflects the amount being financed, the interest rate, the timing of the payments and any other cost that make up the finance charge, such as points, origination fees, processing, etc. The reason for APR variances between lenders is because different lenders include or exclude various costs.
When applicable, the following fees ARE generally included in the APR calculation:
- Points-both discounts points and origination points
- Pre-paid interest
- 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
Because of the various charges made in connection with a loan, the APR is invariably higher than the rate of interest that the lender quotes for the mortgage.
Calculating APRs on adjustable and balloon loans is even more complex because future rates are unknown. Who knows what the index of the LIBOR will be at 15 years from now? So, the program necessarily makes certain assumptions, some of which are “guesstimates”. “Point”, the software program that we and a majority of lenders use, does these calculations internally.
Although it has obvious value, looking solely at the APR is a flawed way to comparison shop for a mortgage and can cause borrowers to make costly wrong decisions. The problem is that the APR calculation makes some very bad assumptions. First, APR assumes zero inflation and that the value or buying power of a dollar today will be exactly equal to the value of a dollar 10, 20, or even 30 years from now. Next, the APR calculation assumes that the mortgage will never be prepaid or paid off. That means no refinancing or selling the home...highly unlikely since the average life of a home mortgage loan is less than four years. It is rare to see the same loan in place for even 5 years—let alone 30 years. Also, the APR calculation does not consider the value of the money used for fees. So if you spent thousands of dollars in points or fees to get a lower rate, the APR calculation does not give any value to the money if it were not spent on closing costs. Nor does APR take tax consequences into consideration. This can be significant since higher fees on the mortgage may not be deductible while the higher interest rate is deductible. Finally, APR can be manipulated by assuming a closing on the last day instead of the first day of the month which would increase the amount financed and decrease the APR.
Based on the foregoing, one should never choose a loan based on APR alone. One would in all cases want to know: the interest rate, points, fees, PMI payments (if any) and then compare these numbers in conjunction with the APR to decide which is best.
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