ANNUAL PERCENTAGE RATE . . .
WHAT DOES IT REALLY TELL A BORROWER?
Annual Percentage Rate (APR) continues to be a source of considerable
confusion for those who purchase or refinance a home. Federal law requires
lenders to "disclose" an APR calculation to every home mortgage
borrower within a few days of receipt of a valid loan application. THE APR DOES
NOT AFFECT YOUR MONTHLY PAYMENTS! Your monthly payments are a function of the
interest rates and the length of the loan.
The APR was designed to help borrowers compare mortgage programs that charge
different rates, fees and points. It is anticipated that the APR calculation
expresses the "cost" of the financing acquired in a home loan. The
problem is that APR is complicated, confusing and easily manipulated by
unscrupulous lenders. Perhaps, more importantly, APR is virtually worthless
because of the assumptions it makes in its calculations. (more
about this later)
There are three main variables in the APR calculation . . . Rate, Amount
Financed and Payment. If any two of the three variables are known, the third
can be calculated. Sounds simple, but the tricky part is the Amount Financed.
Most borrowers think that this is the same as the actual mortgage amount to be
borrowed, but it is not. It is this difference between the Amount Financed and
the Loan Amount that creates the difference between the APR calculation and the
actual interest rate on your mortgage.
The Amount Financed is for disclosure purposes only and is determined by
subtracting the costs associated with obtaining the loan from the amount of the
mortgage. The total costs include things like points, appraisal and credit
report fees and other mortgage company related fees, attorney fees, title
company or home inspection fees and payoff fees (in the case of a refinance)
but all are not included in the APR calculation.
Since the identified costs are then deducted from the mortgage amount, the
amount financed will be a lower number than the actual mortgage. This can cause
considerable confusion, if not panic, for borrowers when they suddenly think
that their loan amount has been reduced. The lower the Amount Financed in relationship to the loan amount the greater the
cost of the loan.
reason why APRs are confusing is because the rules for computation are not
The APR's shown in the media, with rare exceptions, assume a loan amount of
$100,000. The fees in such sample scenarios do not generally include all of the
settlement costs. Mortgage insurance is not included unless a borrower is
identified as requiring it. Settlement costs that are not a part of the cost of
credit are also often not included. These items include closing fees, title fees,
recording fees and city, county or state taxes. To make it a bit easier here is
a list of fees usually included and those that are not included in the APR
The following fees ARE generally included in the APR:
Points – both discount and origination points
Pre-paid interest – the interest paid from the
date the loan closes to the end of thee month. Most mortgage companies assume 15 days
of interest in their initial calculations.
However, companies may use any number between 1 and 30 days.
Loan Processing Fee
Document Preparation Fee (charged by the lender)
Private Mortgage Insurance
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
Document preparation (charged by the closing agent)
Home Inspection fees
Now, let's look at a simple example:
First, we calculate the monthly payment amount for a $100,000 loan at 6% for
30 years . . . $600.66.
Next, we identify the estimated costs for acquiring the loan . . . These include the fees noted above. We will estimate the expenses
for acquiring the loan as $3500. We then subtract this amount from the loan
amount to determine the Amount Financed as $96,500.
Now, we calculate the interest rate for the Amount Financed for 30 years
with the payment as $600.66 to provide an APR of 6.34%. This is obviously
higher than the 6% note rate and the .34 represents the "cost" of
acquiring the loan.
While this seems to be a simple way to compare various loans, it is not
reliable. For instance, one of the fees included in the APR calculation is
Interim Interest . . . The daily interest charged from the day of closing
escrow until the end of the month. With all other costs identical, if one
lender were to provide an APR with an estimated closing date early in the month
vs a lender showing an end of month closing date, the
APR's could vary considerably. Manipulating the closing date and the estimated
interim interest is one of the easiest ways to reduce the APR figure. Estimating a close of escrow at the end of the month, rather than
earlier in the month, will result in a more favorable (lower) APR calculation.
But, even this isn't the worst part of trying to rely on the APR. There are
two very bad assumptions that are assumed in every APR. First, the assumption
that the value of a $1 today will be exactly the same 15 or 30 years from now
(depending upon the term of your loan). Secondly, the APR calculation assumes
that the loan will exist for the entire 15 or 30 year term. In other words, the
homeowner will not move, refinance or prepay the loan . . . An unrealistic
assumption in most cases.
The APR for Adjustable Rate Mortgages (ARM loans) is based on even more
estimates and forecasts, making such calculations even less accurate.
So, while we don't suggest that you ignore the APR calculation, we recommend
that you compare the actual estimate of fees and points rather than relying
upon the unreliable APR figure. Remember that every lender determines the
"yield" they wish to acquire when placing any loan. This yield is a
combination of the interest rate and fees charged. Simply put, this means that
you can sometimes pay less fees and accept a higher
interest rate or pay more fees to acquire a lower interest rate.
Make sure you review the estimated cost sheet for any loan option and ask
questions regarding any fee that you do not fully understand. Finally, there is
probably no substitute for trusting your instincts when selecting the mortgage
person with whom you decide to acquire your loan. You'll soon recognize the
mortgage lender who demonstrates a genuine desire to do that which is best for
you, who takes the time to explain all of your loan options, provides the
education you need to make good decisions and makes sure you understand the
costs involved in borrowing money. That is the person you want to work with and
you will not need an APR calculation to help you make your decision.