Annual Percentage Rate Explained

By Susan M. Keenan

The annual percentage rate or APR, required by the Federal Truth in Lending Law, is calculated using a formula. Designed to help consumers compare mortgage lenders and mortgage products, the APR is an interest rate that reflects the total cost of acquiring the loan on an annual basis for the consumer. Basically, the APR depicts the relationship between the total amount borrowed and the cost of the acquisition of the borrowed amount expressed in terms of a yearly percentage.

Different vendors use different formulas to calculate the APR, and therefore, a true comparison of loans using the APR is not always possible. Many companies will use software programs to calculate the APR on the different loans that they offer. Due to this fact, some mortgage consultants may not even know which fees are being included in the calculations.

The main purpose of the APR is to prevent lenders from advertising low interest rates and then hiding additional fees on the loan to make up the difference. Consumer who are borrowing money and acquiring a loan should look at the APRs of each loan they are considering. If an APR of one loan is much higher than the APR on a similar loan with a different company, then that is an indication that something is different, such as higher fees. Therefore, a lower APR does not necessarily mean a better loan.

For example, one mortgage lender may offer a 30-year fixed rate loan with an interest rate of 8.5%. Another mortgage vender may offer a 30-year fixed-rate loan with an interest rate of 7%. On the surface, the second loan looks better. However, the second mortgage lender is also charging 3 points or 1% of the amount of money that is being borrowed for the privilege of acquiring the 7% interest rate. Depending on the amount of the loan, this equates to quite a few thousand dollars of additional cost. Since points are included in the APR, this number will be slightly higher for the second mortgage loan than the APR for the first mortgage loan. It will be a tip-off that those extra fees may be higher with the second loan.

Since APR calculations take into account additional expenditures associated with the loan, the final figure is always higher than the interest rate that is attached to the loan. However, this does not affect the amount of the monthly mortgage payment. The monthly mortgage payment is calculated solely from the amount of money that you borrow, the principal, and the amount of money that you are charged for borrowing the money, the interest.

When acquiring a loan, the borrower incurs various charges. Many of the fees or charges are standard across the board. Additionally, the mortgage vendor has control over certain fees, while no control is available on fees generated outside the mortgage company. Furthermore, specific fees are usually included in the calculation of the annual percentage rate, some fees are occasionally included, and some are never included in the calculation.

Fees usually included in the APR:

Loan processing fee
Document preparation fee
Underwriting fee
Private mortgage insurance cost, if applicable
Discount points
Origination points
Pre-paid interest amount

Fees occasionally included in the APR:

Credit life insurance cost
Loan application fee

Fees rarely included in the APR:

Attorney fee
Notary fee
Title fee
Recording fee
Escrow fee
Credit report
Appraisal fee
Transfer taxes
Document preparation fees
Home inspection costs

While the annual percentage rate reflects the borrower’s annual cost of acquiring this credit or loan, it does not reflect other, more specific pieces of information. Listed as an interest rate only, the APR does not indicate what the specific fee amounts are, nor does it reflect the length of time that the borrower’s interest rate is locked in. Calculating APRs on adjustable rate or balloon loan mortgages becomes even murkier than calculating APRs on fixed-rate mortgages.

Borrowers of credit are cautioned to use the APR to compare similar loans only. For example, the terms of the loans, or number of years that the loan will be in place, must be identical. The APR for a 30-year fixed-rate mortgage cannot be compared with the APR of a 15-year fixed-rate mortgage. Since one is amortized over a shorter time, the APR may naturally be lower.

Additionally, the larger the amount of the loan, the smaller the impact the additional fees will have on the APR. Smaller loans, such as home improvement or home equity loans, will reflect greater variations in APR due to variations in the costs associated with acquiring the loans.

Important facts to remember:

Use the APR for comparison purposes only.
Only compare similar loans with the APR.
Ask the lender to identify the fees that are included in their APR calculation in order to determine the usefulness of the comparison.
Acquire a good faith estimate from the lender.
Research and shop around for the best possible rates.

The annual percentage rate, or APR, is a useful comparison tool. Remember to look at this number as well as the interest rate that is associated with the loans that you are considering.