Understanding APR

APR stands for Annual Percentage Rate. It is one of the most misunderstood numbers people find when applying for loans. As consumer loans and mortgages in particular turned more complicated it became necessary to help regulate the way lenders advertise and notify the potential borrower of his interest rates. The attempt was to help people compare similar loans from different lenders and to explain the ultimate cost of credit. The APR is defined as the cost of credit to the borrower in relation to the amount borrowed expressed as a yearly rate. This is required by the Federal Truth in Lending Act, Regulation Z.

When you apply for a mortgage the Federal Truth in Lending Disclosure form will be sent. At the top of the page you will see lots of numbers. Two of those numbers are the Note Rate (the actual rate used to calculate your monthly payments) and the Annual Percentage Rate (APR). The Annual Percentage Rate will most always be slightly higher than the note rate because the APR includes other items associated with obtaining a mortgage.

Did you need an interest rate to get a mortgage? Of course, but you also needed some other things. Origination fees, points, mortgage insurance premiums, inspections, prepaid interest and other items may also be required to obtain a mortgage. If so, these things need to be included when calculating the APR. Why is the APR useful? I'll give you an example.

We offer a 30 year fixed mortgage for 8.00%. Some Bank offers a 30 year fixed mortgage for 7.00%.

Easy choice, right? Maybe. Before lenders and mortgage brokers were required to state the APR it was hard to tell. Some Bank has the lowest Note Rate but neglected to mention a few other items. There were also 7 points, an origination fee, and mortgage insurance required. We had no points, no origination and just prepaid interest (your first month's house payment). On a $100,000 loan, Some Bank charged an additional $10,000 when compared to our fixed rate loan. You could save an additional sixty-eight bucks per month with Some Bank's mortgage but you had to pay $10,000 for the privilege. The $10,000 must be included as a cost to obtain the mortgage and is reflected in the APR number.

Here's another example. Mr. Smart Buyer want to buy a $85,000 home. The Builder of the project they really like has a home and offers an interest rate similar to what they could get with us. The Builder quotes 6.00% fixed with no points. We also quote 6.00% with no points but had an origination fee equal to 1 percent of the loan amount (for all practical purposes an origination fee is another name for a 'point' if it is expressed as a percentage of the loan).

BUT WAIT! The Builder failed to disclose there was a 2 percent origination fee! What looked like a better deal at the Builder's lender turned out to be higher. If the APR's were given, it would be evident.

In this instance, the APR for the Builder would be 6.24% and our APR calculates to 6.15% due to the higher fees charged by the Builder. Even though the note rate (the rate used to figure monthly payments) was the same, it cost more at the Builder. Therefore, Mr. Smart Buyer (the name is more than just a coincidence) chose the mortgage from us.

There are many other examples, but if I've still got your attention thus far, I won't want to lose you with boring annual percentage rate stories. Except this one.

The higher the loan amount, the less impact additional fees or points will have on the APR. Why? If you obtain a mortgage with $2,000 of closing costs and you borrow $10,000, then the $2,000 will be nearly 20% of the loan amount. This increases the cost of your money dramatically. Usually home equity or home improvement loans show a higher disparity between note rate and APR because of this. Likewise, if you borrow $100,000 and have $2,000 of closing costs then the fees wont make as significant an impact on the cost of the funds. The bottom line is the APR is your friend, a way to compare like mortgages.

BUT WHAT ABOUT the fees used to calculate the APR? There are some fees that are excluded from the calculation. Below you will find fees typically included when calculating APR:

1. Origination fees
2. Points
3. Buy down funds from the buyer
4. Prepaid mortgage interest
5. Mortgage insurance premiums
6. Other lender fees (application, underwriting, tax service, etc.)

Other fees such as title insurance, appraisal and credit are not included in calculating the APR. The idea here is these other fees are not coming from the lender, and they would be charged anyway, although in the real world, this also may not be true. Like I said, we're talking Federal Government here.

Most states now have laws that require the lender or broker to state the APR in their advertisements. When you compare APR's, ask the lender which additional fees are included when calculating their APR. If they don't know the answer you may want to find a lender that does know. APR's are a way of helping the consumer determine the best loan. Get to know your new friend!

Next page: Buying a Home – Who Does What?