APR, what is it and why it doesn’t matter

You see APR after every interest rate quoted, whether it’s for an auto loan, credit card or a mortgage loan.  What does mean?  How is it calculated?  Does it really matter in the larger scheme of things?  All good questions.

APR means “Annual Percentage Rate”, which is a number that is supposed to somehow tell you the “true” cost of a loan.  The idea is that this number reflects the actual cost of a loan based on any fees required to originate and fund it.  With credit cards the interest rate and the APR are almost always the same because they just give you the credit card and there are not  closing costs involved.  Same with most auto loans.  But with mortgages the quoted interest rate and the APR are almost always different.  Here’s why.

APR is figured by subtracting the fees associated with originating a loan from the loan amount than re-amortizing the payments you’ll make to come-up with “true” cost of the loan.  So if your loan is $200,000 and there are $7,000 worth of fees associated with the loan, the APR would be the dollar amount of actual payments over the term of the loan recalculated into $193,000 rather than $200,000, hence the sum is a higher percentage.

Originally, our government came-up with this figure in an attempt to simplify the home loan shopping process since a borrower could go around to various lending institutions armed with this one figure to see who had the best deal.  However, it doesn’t really work that way because there are way to many variables, both in loan products and in what is considered an “APR item”.

First lets look at what are considered APR items.  HUD says that any fee associated with originating a loan that would not be associated with a cash transaction is an APR item.  However even that is left to the lender’s discretion.  For instance, on the Good Faith Estimate anything in the 800-series section should be considered an APR item as well as Per Diem interest (the interest that has to be prepaid from the closing date of your loan to the first day of the next month) and of course things like up-front fees for mortgage insurance or funding fees through the VA and escrow fees from a title company or attorney.800-section-gfe1

Some of these items are self-explanatory, such as “Loan Origination Fee”, “Credit Report”, “Mortgage Broker Fee” and “Underwriting Fee” because you wouldn’t have those fees if cash were exchanging hands.  However some other such as appraisal and title escrow fees could or could not be included, and lenders use this to their advantage when quoting you so that their fees/APR will look more competitive.  They will leave-out appraisal and title fees since in a cash transaction you may not get an appraisal done or have a title company handle the money transaction or issue a title insurance policy.  But lets face it, it would be financial suicide to buy a home without knowing how much it’s really worth and having a third party handle the transfer of funds from buyer to seller is the safest way to go since they won’t release the funds to the Seller until the title is recorded with the County Clerks office the the Buyer is the legitimate owner of the property in it’s entirety.   Also, title insurance guarantees the buyer that the title is clean and free of encumbrances (liens from collection agencies, bail bonds, contractors, angry neighbors, etc.) and guarantees that if one shows-up for the Seller after the transaction that it won’t effect the Buyer.

So the smart move, even in a cash transaction, is to get an appraisal and use a title company or attorney to complete the transaction and get title insurance.  So legitimately these fees should be included, but many lenders don’t to be more competitive in their quotes.

Second, APR is calculated assuming the loan will be held to term (10, 20, or 30 years) and never refinanced or the house sold.  The fact is that people move on the average of every 7 years and refinance every 4, racially skewing the APR calculation and making it worthless in the real world.

So in my opinion, the only figures that matter in a purchase or refinance transaction are:

  1. What’s the interest rate?
  2. What’s the monthly payment? (Remember, the lowest interest rate doesn’t always equal the lowest payment)
  3. What are the closing costs involved?
  4. How long will it take to amortize and recoup the closings costs? ( In a refinance scenario)
  5. Who is paying the closing costs? (In a purchase scenario)

This is where a mortgage professional can sit down with you in person and answer these questions for you and show you the mortgage options available to you.

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