A Simple Explanation of APR (Annual Percentage Rate) on a Mortgage Loan

The APR, or Annual Percentage Rate, is among the most confusing numbers you will find in mortgage lending. Not only is it one of the most frequently asked questions by clients, few loan officers truly understand it!

Why is APR Used?

The APR calculation is a mandatory figure that mortgage lenders must disclose to their customers, or potential customers, in advertising and on various documents throughout the loan process.

This government regulation was intended to provide consumers with a single figure that could be used to compare various offers from different lenders, so that you can compare “apples to apples”.

The Dilemma

Let’s say you apply for a $100,000 loan from two lenders.

Lender A’s offer:
6.00% Interest Rate
$3,000 Loan Fees
$599.55 per month payment
Lender B’s offer:
6.25% Interest Rate
NO Loan Fees
$615.72 per month payment

One has a lower payment, but the other has lower fees. So, which is a “better” deal? The Annual Percentage Rate attempts to answer this.

How it Works

The theory goes like this… If Lender A, above, gives you that $100,000 loan, but at the same time takes a fee of $3,000… he really only gave you $97,000, right?

BUT remember… you are still paying back the full $100,000 and your payments are based on that loan balance of $100,000.
If we work backwards (with the help of a financial calculator) we can figure out what your interest rate would have been on a $97,000 loan but with the same $599.55 payment that we must make each month. We call this hypothetical interest rate the “Annual Percentage Rate”.

In this example, the APR works out to 6.29%.

Since Lender B charged no fees, the APR on his loan offer is the same as the interest rate, at 6.25%. As you can see, the lower interest rate may sound better, and offers lower monthly payments, but the APR suggests that it is actually a more expensive loan.

Is APR Really a Good Way to Compare Loans?

Not necessarily. Although the math itself is correct, there can be some major traps in relying on the Annual Percentage Rate alone for your decisions.

“Legal” deception in advertised APR’s

In addition to the lender’s loan fees, discount points, and other charges, the APR calculation also includes many other fees, particularly the escrow company’s fees. Lenders often purposely underestimate those fees, resulting in an artificially low APR. Don’t rely on advertised Annual Percentage Rates.

The Effect of Time

One of the biggest factors that the APR calculation does not take into account is time… that is, how long you plan on keeping the house. Few homeowners will own their home for the full 30 years, without ever refinancing or selling. However, most borrowers are drawn to the lowest interest rate, and don’t give much thought to the cost of getting that rate. Generally speaking, it takes 4-7 years before the lower mortgage payment from a lower interest rate catch up to the extra costs it took to get that rate. Believe it or not, it is very often a better choice to opt for lower fees and a higher rate. Your loan officer will show you, and help you decide. You may be surprised!

Your Finances

While some buyers are fortunate enough to have plenty of funds available, many borrowers are a little stretched to come up with their down payment and closing costs. Getting settled in a new home can be expensive. While a lower rate may look better, lower loan costs will leave more money in your pocket for those expected wants and unexpected needs.

How Do I Make the Right Decision?

Most importantly, pick a reputable loan officer. Trust your instincts. Don’t just listen to ads and quotes, and don’t just count on the big bank names you know. Yes, you want a good rate, but you also want knowledgeable advice and great service. Most lenders’ rates don’t differ all that much… so with all those “bait and switch” lenders still too common, be careful if it sounds too good to be true! You probably wouldn’t pick the cheapest attorney, heart surgeon or pilot… don’t settle for less when it comes to the largest financial transaction most of us ever make.

Discuss your future plans with your loan officer. Talk about your options and your concerns. A good loan officer is your advocate, and we’ve heard it all! Don’t hesitate to share your thoughts and ask for advice.

Karyn WegerKaryn Weger has been in mortgage lending for over 20 years.

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