Annual Percentage Rate - (APR)

What is an Annual Percentage Rate (APR)?

The annual percentage rate (APR) is an interest rate that is different from the note rate. It is commonly used to compare loan programs from different lenders. The Federal Truth in Lending law requires mortgage companies to disclose the APR when they advertise a rate. Typically the APR is found next to the rate. The APR does not affect your monthly payments. Your monthly payments are a function of the interest rate and the length of the loan.

The APR can sometimes be a very confusing number! Even mortgage bankers and brokers admit it's confusing. The APR is designed to measure the "true cost of a loan." It creates a level playing field for lenders. It's intention is to prevent lenders from advertising a low rate and hiding fees.

In a perfect world, all you would have to do is compare APRs from the different lenders/brokers whom you are working with. The lowest one would be the best loan. Right? Wrong!

Unfortunately, lenders calculate APRs differently! So a loan with a lower APR is not necessarily a better rate. 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 (ex. 30-year fixed) at the same interest rate. Then delete all fees that are 3rd party or independent fees such as homeowners insurance, title fees, escrow fees, attorney fees, etc. Now add up what is remaining. The lender that has lower loan fees has a cheaper loan than the lender with higher loan fees.

The reason why APRs are confusing is because the rules to compute APRs are not clearly defined. Let's look at some of the problems:

What fees are 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! So be cautious of thus lenders that include only 1 day of pre-paid interest.
Loan-processing fee
Underwriting fee
Document-preparation fee
Appraisal fee
Credit-report fee

The following fees is sometimes included in the APR:

Loan-application fee

The following fees are normally not included in the APR:

Title or abstract fee
Escrow fee
Attorney fee
Notary fee
Document preparation (charged by the closing agent)
Home-inspection fee
Recording fee
Transfer taxes

Another problem is that APR does not tell you how long your rate is locked for. A lender who offers you a 7-day rate lock may have a lower APR than a lender who offers you a 60-day rate lock!

Calculating APRs on adjustable and balloon loans is even more complex because future rates are unknown. Many companies assume future rates to be quite low when they compute their APR.

Also, don't 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.

Finally, many lenders do not even know what they include in their APR because they use software programs to compute them. It is quite possible that the same lender with the same fees using two different software programs may arrive at two different APRs!

A good suggestion is to use APR as a starting point to compare loans. However, APR is a result of a complex calculation and not clearly defined. There is no substitute to getting a good-faith estimate from each lender to compare costs. Remember to exclude those costs that are independent of the loan. And as always, contact Allie Mae for advice.


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