What is an APR?
The APR, often referred to as the Effective Rate, is a rate which
shows the true cost of borrowing. This rate is different from the
nominal (named or note) interest rate stated in your loan
documents. The Truth In Lending Simplification and Reform Act
requires mortgage companies to disclose the APR when advertising a
rate.
To begin to understand the Annual Percentage Rate, it helps to
understand the standard, fixed rate mortgage loan. A standard loan
consists of:
- Loan amount
- Number of payments
- Monthly payment amount
- Nominal interest rate
Given any three of the above four items, the fourth can be
determined with the aid of a financial calculator, computer
program or algebraic formula. In other words, given any three
factors, there is only one correct fourth factor. Here is an
example of a fixed rate loan:
| 1. Loan amount: |
$100,000 |
| 3. Number of payments |
360 (12 payments per year for 30
years) |
| 4. Monthly payment |
$804.62 |
| 2. Interest rate |
$9% |
Let's consider a simplified, real estate loan transaction,
using the above loan as our starting point. You borrow $100,000
and pay a 1.5 percent loan fee to the bank. For this example, that
is the only fee you pay. At the completion of the transaction, how
much money do you have? $100,000? No. You have $100,000 less the
$1,500 loan fee, or $98,500.
Taking into account the cost of your transaction, let's take a
second look at your new loan.
| You received |
$98,500 |
| Number of payments |
360 |
| Monthly payment |
$804.62 |
| Interest rate |
? |
Remember, there can be only one correct interest rate given the
other three factors. In this example, the interest rate is the
APR--9.17 percent. Since the loan amount was effectively reduced
(you didn't get $100,000), and the number of payments and monthly
payment stayed the same, the interest rate had to increase.
Fundamentally, that's all there is to the APR in a real estate
loan transaction. This simplified example recognized only one fee
related to obtaining a loan. You'll incur many other costs when
obtaining a loan, some effecting the APR, some not, but the
principle is the same.
Theoretically, the APR is a number you can use to accurately
compare loans among different lenders. Since the APR takes into
account costs of obtaining the loan, you should be able to use
APRs to find the best loan. Unfortunately, when calculating the
APR, not all lenders include all fees, and some lenders may
include fewer fees than another lender. What's a borrower to do?
Ask for a signed and dated Good Faith Estimate of Closing Costs
(GFE). A properly prepared GFE will itemize all the costs
associated with your loan. Only then can you accurately compare
lenders' programs.
What fees are included in the APR?
The following fees are usually 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 (insurance that pays off the mortgage
in the event of a borrowers death)
The following fees are usually not included in the APR:
- Title or abstract fee
- Escrow fee
- Attorney fee
- Notary fee
- Document preparation (charged by the closing agent)
- Home-inspection fees
- Recording fee
- Transfer taxes
Points to remember
An APR is a starting point from which to begin to compare loans.
You must get a signed and dated Good Faith Estimate of Closing
Costs with which to accurately compare lenders' programs. |
