What is an Annual Percentage Rate (APR)?

The Annual Percentage Rate (APR) is an interest rate that is different from the note rate. When someone says that they have an 8% mortgage, they are referring to the note rate.  That is the rate that is the basis of monthly payments. It is a function of the interest rate and the length (term) of the loan.  It is commonly used to compare loan programs from different lenders. The Federal Truth in Lending Act (also known as Regulation Z) requires mortgage companies to disclose the APR when they advertise a rate. Typically the APR is found next to the note rate.

Even mortgage bankers and brokers admit the APR can be a very confusing number. The APR measures the "true cost of a loan." It creates a level playing field for lenders and prevents them from advertising a low rate and hiding fees.  Unfortunately, the law does not provide a uniform method for calculating the APR, therefore different lenders do it differently.  Legislation has been introduced to correct this oversight, but it will be some time before it passes.

The best way to compare loans is to ask each lender to provide you with a "Good Faith Estimate" of their costs on the same type of program (e.g. 30 yr fixed) at the same interest rate. Then delete all fees that are independent of the loan, such as homeowner's insurance, title fees, escrow fees, attorney fees, etc.  Then, add up all the loan fees.  The lender that has lower loan fees has a cheaper loan than the lender with higher loan fees.  This function is normally done for you by your mortgage broker, if you use one.

What fees are included in the APR?

The following fees are generally included in the APR:

• Points - both discount points and origination points.
• Pre-paid interest. 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, companies may use any number between 1 and 30!
• Loan Processing Fee
• Underwriting Fee
• Document Preparation Fee
• Private Mortgage Insurance
• Appraisal Fee
• Credit Report Fee

The following fees are sometimes included in the APR:

• Loan Application Fee
• Credit Life Insurance

The following fees are normally not included in the APR:

• Title Fee
• Escrow Fee
• Attorney Fee
• Notary Fee
• Document Preparation Fee
• Home Inspection Fee
• Recordation Fee
• Transfer Taxes

Comparing Rates:

Calculating APRs on adjustable and balloon loans is even more complex, because the future rates are unknown. The result is even more confusion about how lenders calculate APR's.

Do not attempt to compare a 30 year loan with a 15 year loan using their respective APRs. A 15 year loan may have a lower interest rate, but could have a higher APR, since the loan fees are amortized over a shorter period of time.

Conclusion:

Use the APR as a starting point to compare loans. The APR is a result of a complex calculation and not clearly defined. There is no substitute for getting a Good Faith Estimate from each lender to compare costs.  To clarify the difference between loans, remember to exclude those costs that are independent of the loan.

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