It is also 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 their 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:
Great Big Bank offers a 30 year fixed mortgage for 8.00%. Really Small 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. Really Small Bank has the lowest rate (note rate) but neglected to mention a few other items. There was also 7 points, an origination fee, and mortgage insurance required. Great Big Bank had no points, no origination and just prepaid interest (your first months house payment).
On a $100,000 loan, Really Small Bank charged an additional $10,000 when compared to Great Big Bank’s fixed rate loan. You could save an additional sixty-eight bucks per month with Really Small 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. and Mrs. Smart want to buy a $85,000 home. The Developer of the project they really like has a home and offers an interest rate similar to what they could get at their Credit Union. The Developer quotes 6.00% fixed with no points. The Credit Union also quotes 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 Developer failed to disclose there was a 2 percent origination fee! What looked like a better deal at the Developer’s lender turned out to be higher. If the APR’s were given, it would be evident. In this instance, the APR for the developer would be 6.24% and the Credit Union APR calculates to 6.15% due to the higher fees charged by the Developer. Even though the note rate (the rate used to figure monthly payments) was the same, it cost more at the Developer. Therefore, Mr. and Mrs. Smart (the name is more than just a coincidence) chose the mortgage from their Credit Union.
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 won’t make as significant an impact on the cost of funds. The bottom line is the APR is your friend, a way to compare like mortgages.
The Fees used to calculate the APR?
There are some fees that are excluded from the calculation but below you will find fees typically included when calculating APR:
1. Origination fees
3: Buydown 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. Many states now have additional laws that require the lender or broker to state the APR in their advertisements beyond the requirements of the Federal Regulation. When you compare APRs, 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. APRs are a way of helping the consumer determine the best loan. Get to know your new friend!