When shopping for a mortgage, most borrowers are attracted to the initial mortgage rate, but don’t know much about the annual percentage rate (APR). While looking at the mortgage rate is a good place to start, it does not provide the borrower with complete picture. The APR represents the total cost of borrowing the funds.
Understanding the APR can be difficult, but it is essential to understanding the real costs of a loan. The mortgage rate alone should not be used to make a mortgage decision.
Through disclosure of the APR, the borrower is given the full information and cost of the mortgage and can then compare different offers before making a final decision. For instance, if you receive one loan offer with an APR with 4.27% and another one at 4.89% APR, it may be an indication that the offer showing a 4.27% APR is better.
The APR reflects not only the interest paid on the loan, but also any charges associated with opening the loan. Because of this, borrowers will find that the APR is usually higher than the interest rate of their loan.
Let’s look at a comparison between the base interest rate of a loan, and the loan’s APR.
The Simple Interest Rate
Before we understand the APR, we have to understand what the interest rate is. The simple interest rate of a loan reflects how much interest the borrower will pay per year on the loan balance. For instance, on a $100,000 loan with a 4.0% interest rate, the borrower would pay $4,000 per year in interest, or $333.33 per month.
But, this calculation would only apply to a mortgage that requires only interest to be paid. Otherwise, interest is paid on the current balance only.
For this reason, the borrower will pay slightly different amounts of principal and interest each month, even though the entire payment is staying the same. As shown on this graph, the amount of principal paid each month goes up, while the amount of interest paid each month goes down, as this graph indicates.
The simple interest rate only addresses the amount of interest charged per year on the existing loan balance. But APR factors in simple interest rate plus loan fees.
For just about every loan that is originated, lenders charge fees in relation to opening that loan. It takes work and overhead costs to process a loan from start to finish, so the bank needs to charge fees to cover costs and make a profit.
The APR reflects not only the simple interest (4.0% per year in the previous case), but also reflects fees like points, processing fees, underwriting fees, mortgage broker fees, mortgage insurance premiums, and other lender fees that the borrower is required to pay as part of the mortgage transaction.
The APR does not include third party fees, such as appraisal, title expenses and inspections.
The higher the cost of fees associated with the loan, the higher the APR. Let’s imagine that our $100,000 loan with a 4.0% interest rate had $5000 in APR fees. If this were a 30 year loan, the borrower would pay $71,869 in interest over the life of the loan. Including the $5000 in fees, the total amount that the borrower pays to have the mortgage is $76,869. This amount is a bit higher than just the amount paid in interest, and is the number used to calculate the APR.
What the APR Assumes
The calculation of the APR is based on the assumption that the mortgage will not be refinanced, but will be held by the borrower for the agreed term of the loan which is usually 15, 20, or 30 years.
As a result, an APR for a 20 year loan should not be compared to the APR for a 30 year loan.
When shopping for various types of loans, be sure to get a Truth in Lending form (TIL), which is a disclosure that states the loan’s APR. Only compare 30 year fixed TILs to other 30 year fixed TILs. Otherwise you’ll be comparing apples to oranges.
APR and Adjustable Rate Mortgages
Things get really interesting when talking about the APR for an Adjustable Rate Mortgage (ARM). This calculation is different from the APR calculation for a Fixed Rate Mortgage (FRM).
The APR calculation for an ARM is based on the current index and margin related to that ARM. ARMs may be fixed for a period of time, usually 3, 5, or 7 years, then their interest rates start adjusting.
The APR on ARMs is determined based on what the interest rate would be if the loan started adjusting that day. So, if the ARM interst rate goes up or down at all during the life of the loan, the APR will be inaccurate. Since ARM rates change every year or even many times per year, it’s pretty certain that looking at the ARM APR is not a reliable way to see the total cost over the life of the loan.
Bottom line: looking at APRs on ARM loans may help when comparing two loan offers from banks. But don’t use the APR to estimate the total cost over the whole loan term.
APR on FHA Mortgages and PMI Mortgages
You should know about what happens to the APR on FHA loans and conventional loans with private mortgage insurance (PMI). Like was discussed before, the APR reflects the entire cost of the loan over the entire life of the loan. One cost of the loan is mortgage insurance.
On FHA and PMI mortgages, the APR might be significantly higher than the base rate. For example, an FHA loan might have a rate of 3.25% but an APR of 5.10%. What gives?
The APR takes into consideration the dollar amount paid in monthly mortgage insurance for both FHA and PMI mortgages. On an FHA loan, the yearly mortgage insurance cost is 1.35% of the outstanding balance. That’s $1,350 in the first year alone on a $100,000 mortgage. Each year, another 1.35% of the current outstanding balance is charged. This is why the FHA APR looks so high. It’s not necessarily that the bank is charging you too much.
The same principle applies for conventional loans with PMI. The APR might look a lot higher than the base rate on PMI loans.
Federal Law Regarding APR Disclosure
Federal law requires lenders to openly show both the mortgage rate and the APR when advertising in order to prevent lenders from showing a low rate while hiding fees. Any time a mortgage rate is quoted by a lender, the APR must also be disclosed and be just as visible as the simple interest rate.
Upon completing and submitting a mortgage application, this APR appears on the top of the Truth and Lending disclosure (TIL) form that is received as part of the package of disclosures from the lender. If the APR goes up or down too much during the course of loan processing, your lender is required to send you a new TIL to make sure you know and acknowledge the new APR.
APR and Mortgage Strategy
In looking at APRs, you should know what your overall strategy is for the home and the mortgage. If you know you will sell the home or refinance in 3 years, it can be better to take a higher interest rate with an APR not much higher. For instance, if the rate is 4.25 and the APR is 4.30, it’s an indication that there are not a lot of fees associated with the loan, or that the lender is paying for a lot of the fees.
If you plan to live in the house forever and never refinance, it may be good to take a very low rate with a higher APR compared to the base rate.
For instance, a 3.875% rate and a 4.12% APR indicates higher upfront fees than the previous scenario, but a lower overall cost over the life of the loan. Just watch out and don’t pay too much in upfront fees if you won’t have that mortgage for long.
The APR does not take into consideration a mortgage refinance, selling the home or even making extra payments to pay down principal. It is strictly based on the original loan amount, closing costs, prepaid items and the entire term of the loan until final payoff.
While the APR is designed to present the borrower with the true cost of the loan, the length of time that the borrower holds the loan will, in the end, determine the most accurate and final costs.
While the APR is an important consideration, it should not be the determining factor in seeking a mortgage. The entire mortgage, cost and terms of the loan must be examined by the borrower. After all considerations, the most appropriate mortgage will be the one that the borrower is comfortable to live with, happy with the mortgage rate and satisfied with the costs.