APR (Annual Percentage Rate)
If you're willing to know how much your mortgage costs, the APR or Annual Percentage Rate is what you should watch out for. Lenders are required to disclose the APR as part of the Truth-in-Lending disclosure (as per the Truth-in-Lending Act).
What is APR?
The APR is not the actual rate or note rate advertised by the lender. It is the effective rate which represents the cost of borrowing a mortgage loan. Lenders calculate APR taking into account the closing costs and the interest rate on a mortgage. The Annual Percentage Rate is often used to compare mortgage lenders and the programs they offer. However, it is not an effective tool for lender/loan comparison because a mortgage with high APR may often be a better option compared to one with a low APR.
What fees/costs does the APR include?
Some of the fees/closing costs that the APR includes are:
Points (discount and origination points)
Prepaid interest (from closing date to the end of the month)
Loan processing fee
Underwriting fee
Document preparation fee
Private mortgage insurance
Why is APR not the only factor to compare loans?
The Annual Percentage Rate shouldn't be considered as the only factor to compare mortgage lenders or loans. One should take into account other factors like the interest rate, closing costs and lender fees. The APR assumes zero inflation thereby considering that the value of dollar would remain same even after 10-20 years. But this isn't true. Besides, when lenders calculate APR, they assume that the mortgage won't be paid off early even though the average life span of the loan ranges from 5 to 7 years for most borrowers.
The APR also doesn't consider the value of money used for paying lender fees even though you may use it to get a low rate on your mortgage. Until and unless the fees are added to the closing costs, the lenders won't consider it when they calculate APR.
Here's an example to show why you shouldn't compare loans just by the APRs on offer. Just check out the calculation on how to compare loans with different APR explained below. It will give the idea as to what other factors (besides Annual Percentage Rate) should be considered while comparing loans and which lender has the better offer for you.
Let's consider 2 mortgages - X and Y, both being fixed rate mortgages of the same amount and loan term (30 years).
Loan X has the following details:
Mortgage amount = $200,000
Interest rate = 6%
APR = 6.25%
Lender fees = $5000
The amount financed (loan amount minus fees, points, etc) = $(200,000 – 5000) = $195,000.
Monthly payment = $ 1199.10
Loan Y has the following details:
Mortgage Amount = $200,000
Interest = 6.25% APR = 6.45%
Lender fees = 1500
The amount financed = $(200000 – 1500) = $198,500
The monthly payment = $ 1231.43
The monthly payments on loan X and loan Y differ by = $(1231.43 - 1199.1) = $32.33
From the calculation on loan comparison with different APR explained above, we see that loan X has a low Annual Percentage Rate and requires you to pay lower monthly payment as compared to loan Y. But you need to pay higher lender fees for loan X whereas if you go for loan Y, you can save $(5000 – 1500) = $3500 in fees.
On the other hand, if you go for loan X, you'll save only $32.33 on a monthly basis. Using this savings, you can recoup the $3500 in = (3500/32.33) = 108 months or 9 years. If you'd like to sell the property within the 9 year period, then you won't be able to recoup the extra fees. In such a case, loan Y will cost you less. So, if you'd like to relocate within a short term, say 5-6 years, then loan X isn't the right one for you. Thus, a loan with a higher APR and low fees may be a better option than one with a low APR and higher fees.
