Understanding the Annual Percentage Rate (APR) and What It Really Means In Real Estate

The annual percentage rate (APR) gives you the yearly cost of a mortgage in the form of a percentage. The rate calculations include interest, mortgage insurance, and the origination fee (points).

The APR has two main purposes.

1. it allows borrowers to compare loan programs from different lenders so they can see which program is the cheapest.

2. It creates a "level playing field" for lenders. And, three, it prevents lenders from advertising teaser rates and hiding fees from consumers.

The Federal Truth in Lending law requires mortgage companies to disclose the APR when they advertise their rates. Typically the APR is found next to the rate; for example, "30 year fixed...8%...1 point...8.107% APR."

APRs can be useful for consumers in determining the cost of a mortgage; however, they do have one problem you need to be aware of, and that problem is that APRs can be very confusing because different lenders calculate APRs differently! This means that a loan with a lower APR may not actually have a better rate.

To find out the truth about a particular APR on a loan, you have to do digging and calculations on your own.

The first step is to ask lenders for a good-faith estimate of their costs on the same type of loan (e.g. 30-year fixed) at the same interest rate.

Once you have the estimate, the second step is to delete all fees that are independent of the loan (e.g., homeowners insurance, title fees, escrow fees, attorney fees, etc.

The third step is to add up all the loan fees and then choose the lender with the lowest loan fees.

You may wonder why there's so much confusion about APRs. Well, there are several reasons

Reason 1:

The rules to calculate APR are not clearly defined.

APR is calculated using a complex formula prescribed by the Consumer Credit Act (1980). But, there are three different ways of calculating the Annual Percentage Rate! Lenders must inform you of the APR calculation method before you sign a loan agreement, but that doesn't mean it's easy to understand.

Reason 2:

It's not always clear what fees are included in the APR.

The following information about fees will show you what I mean.

A. Fees generally included in the APR are:

1. Points - both discount points and origination points a. Pre-paid interest. Note: This is 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, some will use any number between 1 and 30.

2. Loan-processing fee

3. Underwriting fee

4. Document-preparation fee

5. Private mortgage insurance

B. Fees sometimes included in the APR:

1. Loan-application fee 2. Credit life insurance (insurance which pays off the mortgage in the event of a borrower's death).

C. Fees not normally included in the APR:

1. Title or abstract fee

2. Escrow fee

3. Attorney fee

4. Notary fee

5. Document preparation (charged by the closing agent)

6. Home-inspection fees

7. Recording fee

8. Transfer taxes

9. Credit report

10. Appraisal fee

Reason 3:

The APR doesn't tell you how long your rate is locked in for. This means that one lender who offers you a 10-day rate lock may actually have a lower APR than a lender who offers you a 60-day rate lock.

Reason 4:

APR calculations for adjustable and balloon rates are complex.

The future rates for adjustable and balloon rates are unknown, so calculating APRs becomes very complex. This results in more confusion for borrowers.

Reason 5:

Comparing APRs of different loans creates false comparisons.

Consumers sometimes make the mistake of comparing the rates of different loans; i.e., comparing 30-year loans with 15-year loans using the respective APRs.

Example: A 15-year loan may advertise a lower interest rate, but have a higher APR because the loan fees are amortized over a shorter period of time. So, don't ever compare the two!

Reason 6:

Different lender computer software programs may calculate different APRs Lenders often use computer software programs to calculate their APRs and don't even know what baselines are used in these programs. Worse, the same lender with the same fees may use two different software programs. It's entirely possible that these programs may calculate two different APRs!

Here are my two recommendations in regard to the APR:

First, use the annual percentage rate only as a starting point when dealing with lenders.

Second, as I mentioned earlier, get good-faith estimates from lenders and then exclude any costs that are independent of the loan.

Key Point: When it comes to APRs, do your homework!

Jack Sternberg