One of the most common incorrectly explained and misunderstood topics within the mortgage business is the definition of APR. I will do my best to unravel the mystery and explain it in a way that is clear and understandable so that next time you ask your lender about APR, you can correct their explanation about exactly what APR is.
Why is APR Used?
APR is part of the Truth in Lending Act that is one main area of regulation within the mortgage business. APR was created to provide one number to determine the cost of a mortgage loan for the purpose of understanding the true cost and provide the ability to easily compare mortgage lenders and determine which one provides the lowest cost to you. Sounds easy, right? Just check one number on the documentation that mortgage loan officers provide and…BAM…done – you know who is best. Not quite.
APR VS Note Rate
One of the main misconceptions or misunderstandings surrounding the APR is that some believe it is the note rate, or the rate of interest the lender will actually collect from you, as the borrower. This is not correct. APR includes other factors than just the rate that you pay the lender back. Here are some of the fees that may be included into the APR calculation:
- Origination Fee
- Discount Points
- Prepaid Interest
- Processing Fee
- Underwriting Fee
- Documentation Prep Fee
- Private Mortgage Insurance
Here is what is funny though – there is no exact rule as to what is and is not included into the APR calculation. Check out two websites I was reviewing before posting:
- Wikipedia – Annual percentage rate
- Yahoo Answers – What fees are included in APR?
- I realize this isn’t the most reliable source, but it explains the point
Between these sites you can see a wide range of beliefs related to what fees are actually included in the APR. This is because the Truth in Lending Act does not explicitly state what has to be included. Here is the wording from the Truth in Lending Act:
- All items required to be disclosed under section 226.4(a) and (b), except interest or the time-price differential.
All compensation paid to mortgage brokers.
- All items listed in section 226.4(c)(7), other than amounts held for future taxes, unless all of the following conditions are met:
- The charge is reasonable,
- The creditor receives no direct or indirect compensation in connection with the charge, and
- The charge is not paid to an affiliate of the creditor.
- Premiums or other charges, paid at or before closing if paid in cash or financed, for optional credit life, accident, health, or loss-of-income insurance, and other debt-protection or debt cancellation products written in connection with the credit transaction (section 226.32(b)(1)).
This is why the same loan with two different lenders could have two different APR calculations. Keep this in mind when you are comparing mortgage lenders.
What is the Definition?
So now that we understand that no one knows exactly how to calculate the APR, what is APR, anyway? Here is the best definition I could find for APR, courtesy of Investopedia:
The annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.
Here is the formula, found on the FDIC website:
My answer – use a software program. Probably every mortgage loan officer uses some sort of mortgage software program to calculate the APR for them, to avoid the confusion of how to calculate the number outside of what should included in the calculation.
So Now What?
Now we are totally confused, right? We don’t know what fees are included, and we don’t know how to calculate it – but, hey, at least you know how confusing it really is and why each lender will likely have a different calculation for you on APR. Knowledge is power though…now that you know that the APR will vary, you can eliminate this as a viable method for determining the best loan to choose from a, merely, financial point of view.
Outside of the 8 Questions to Ask Your Lender post that I provided to help you in selecting a mortgage lender, when comparing just the financial aspects of a mortgage loan here is what I suggest:
- Obtain a Good Faith Estimate from each lender on the same day
- If you get GFEs on different days the rates quoted on the GFEs may be skewed and you will not truly be comparing apples to apples
- Compare the fees in the 800 line items
- These are the fees that the lender is charging and are likely to be the only fees that will truly vary at the time of closing
- Although not all lenders disclose all fees outside of the 800 line items correctly, these fees will be the very close, if not the same, from lender to lender by the time of closing
- Compare the interest rate
- Compare the term (length of the loan)
- Compare the terms
- Is there a prepayment penalty
- Is the payment interest only or fully amortizing
- FHA, VA or Conventional
- What type of MI
- Up-front or just monthly
By comparing these items yourself, you will be able to determine the best loan on your own without relying on the APR calculation that no one quite understands.
Hope this helped confuse the confusion about APR.
Lending A Hand,