APR - Annual Percentage Rate

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In comparing any type of loan, whether it be a fixed rate loan to a fixed rate loan, adjustable rate loan to adjustable rate loan or fixed rate loan to adjustable rate loan, there is one way that can be used to compare apples to apples and even apples to oranges.

 

APRs are designed to do just that. APRs are a way to calculate the annual cost of loans, taking into consideration loan origination fees (points) and the other costs associated with securing a loan. The additional costs include appraisal and credit report fees as well as processing and document fees.
  
As a means of protecting consumers from companies who did not disclose the fees or discount points associated with a particularly low start rate on an adjustable rate loan or below market rate on a fixed rate loan, APRs give consumers a way to check the true cost of a loan.

 

The form that helps you with this information is called the Loan Estimate (LE). It tells you what all of the closing costs are along with information regarding the payments and the calculation of the Annual Percentage Rate or APR.
 
The closing costs consist of 2 types: recurring and non-recurring. In the case of a refinancing, the non-recurring costs are the ones that you have to pay because you are getting a new loan. The new lender needs title insurance, you need an appraisal etc. In the case of "no-cost" or "low-cost" loans we cover these costs by getting you a loan at a sufficiently higher rate so that the investor is willing to pay a premium which furnishes us with the money to cover the non-recurring closing costs, There should be an item on the disclosures that shows the credit for non-recurring costs.

Recurring closing costs are items that you must pay anyway: interest, property taxes and insurance but must pay early as a consequence of refinancing.

We send out disclosures with your loan application.  If the rate, loan program, and cost that we subsequently agree on is not the same as on the initial disclosures, we will send new disclosures. 
 
APR and "Amount Financed"

These 2 items are most often misunderstood by people who do not see these forms every day. To be honest, the APR is probably misunderstood by a lot of people who do see these forms every day.
 
The idea is simple. Let's say that your new loan is $200,000. The "Amount Financed" represents that amount less the prepaid finance charges, which are a portion of the charges shown on the Loan Estimate. If you are borrowing $200,000 and it costs $2,000 to do so then you are only "netting" $198,000. Your loan balance on the day the loan funds is still $200,000.  APR, in this case, is the interest rate on $198,000 which would produce the same monthly payment as the note rate does on the loan amount. It has no meaning other than that. More importantly: once the loan is made, it has nothing to do with anything. It is not the rate that you are paying. Only the note rate has any meaning. Do not base your decision to refinance on the APR of your old loan but on the note rate on your old loan. 
 
Two other things about APR: 1) a loan with a lower APR is not necessarily better than a loan with a higher APR This depends, largely, on how long you keep the loan. That might depend on whether or not rates drop in the future and you can refinance again. 2) in my opinion, for adjustable rate mortgages, APR is of lesser use. It makes less sense to talk about APR if the interest rate in the future is not known. This does not mean that there will be no APR on the disclosures of ARM's. An APR is calculated based on the unlikely assumption that the Index will never change from its present value.

One confusing aspect of APRs is that the APR on 15 year loans will carry a higher relative rate due to the fact that the points are amortized over the 15 year term rather than the 30 year term. When a Loan Estimate is prepared for a buyer/borrower the prepaid interest is also included in the APR calculation. For our illustrations below we will use only the points, appraisal, credit report, processing and document fees.

 

One common situation that occurs when a borrower receives a Loan Estimate as required under TILA-RESPA, and a copy of their note, is the column that indicates the amount financed is less than the loan amount the borrower is actually financing. It is here that many borrowers leap before they look and call to find out why they are only receiving a $146,925 loan when they applied for a $150,000 loan. It is here that APRs enter the picture.

 

Let's look at how APRs are calculated. For our illustration we will assume a 8.50% fixed rate interest. For a 30 year loan the monthly payments for a $150,000 loan are $1,153.37.

 

In order to calculate the APR for this loan we subtract $2,250.00 (1.50 points), $275.00 appraisal fee, $50.00 credit report fee, $500.00 processing, document and other fees. ($150,000 - $3,0750 = $146,925). The $146,925 is then used as the present value/loan amount to determine the true cost of this loan. By solving for the new interest rate for a $146,925 loan with the same payment of $1,153.37, the APR is calculated as 8.73%.

 

How does this compare to a 30 year fixed rate loan with a 8.00% interest rate and 3.50 points? The monthly payments for this loan is $1,100.65.

 

In order to calculate the APR for this loan we subtract $5,255.00 (3.50 points), $275.00 appraisal fee, $50.00 credit report fee, $500.00 processing, document and other fees. ($150,000 - $6,075 = $143,925). The $143,925 is then used as the present value/loan amount to determine the true cost of this loan. By solving for the new interest rate for a $143,925 loan with the payment of $1,100.65 the APR is calculated as 8.44%.