ANNUAL PERCENTAGE RATE… WHAT DOES IT REALLY TELL A BORROWER?
Annual Percentage Rate (APR) continues to be a source of considerable confusion for those who purchase or refinance a home. Federal law requires lenders to “disclose” an APR calculation to every home mortgage borrower within a few days of receipt of a valid loan application. THE APR DOES NOT AFFECT YOUR MONTHLY PAYMENTS! Your monthly payments are a function of the interest rates and the length of the loan.
The APR was designed to help borrowers compare mortgage programs that charge different rates, fees and points. It is anticipated that the APR calculation expresses the “cost” of the financing acquired in a home loan. The problem is that APR is complicated, confusing and easily manipulated by unscrupulous lenders. Perhaps, more importantly, APR is virtually worthless because of the assumptions it makes in its calculations. (more about this later)
There are three main variables in the APR calculation…Rate, Amount Financed and Payment. If any two of the three variables are known, the third can be calculated. Sounds simple, but the tricky part is the Amount Financed. Most borrowers think that this is the same as the actual mortgage amount to be borrowed, but it is not. It is this difference between the Amount Financed and the Loan Amount that creates the difference between the APR calculation and the actual interest rate on your mortgage.
The Amount Financed is for disclosure purposes only and is determined by subtracting the costs associated with obtaining the loan from the amount of the mortgage. The total costs include things like points, appraisal and credit report fees and other mortgage company related fees, attorney fees, title company or home inspection fees and payoff fees (in the case of a refinance) but all are not included in the APR calculation.
Since the identified costs are then deducted from the mortgage amount, the amount financed will be a lower number than the actual mortgage. This can cause considerable confusion, if not panic, for borrowers when they suddenly think that their loan amount has been reduced. The lower the Amount Financed in relationship to the loan amount the greater the cost of the loan.
The reason why APRs are confusing is because the rules for computation are not clearly defined.
The APR’s shown in the media, with rare exceptions, assume a loan amount of $100,000. The fees in such sample scenarios do not generally include all of the settlement costs. Mortgage insurance is not included unless a borrower is identified as requiring it. Settlement costs that are not a part of the cost of credit are also often not included. These items include closing fees, title fees, recording fees and city, county or state taxes. To make it a bit easier here is a list of fees usually included and those that are not included in the APR calculation.
The following fees ARE generally included in the APR:
- Points – both discount and origination points
- Pre-paid interest – the interest paid from the date the loan closes to the end of thee month. Most mortgage companies assume 15 days of interest in their initial calculations. However, companies may use any number between 1 and 30 days.
- Loan Processing Fee
- Underwriting Fee
- Document Preparation Fee (charged by the lender)
- Private Mortgage Insurance
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 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 fees
- Recording fee
- Transfer taxes
- Credit report
- Appraisal fee
Now, let’s look at a simple example:
First, we calculate the monthly payment amount for a $100,000 loan at 6% for 30 years…$600.66.
Next, we identify the estimated costs for acquiring the loan . . . These include the fees noted above. We will estimate the expenses for acquiring the loan as $3500. We then subtract this amount from the loan amount to determine the Amount Financed as $96,500.
Now, we calculate the interest rate for the Amount Financed for 30 years with the payment as $600.66 to provide an APR of 6.34%. This is obviously higher than the 6% note rate and the .34 represents the “cost” of acquiring the loan.
While this seems to be a simple way to compare various loans, it is not reliable. For instance, one of the fees included in the APR calculation is Interim Interest . . . The daily interest charged from the day of closing escrow until the end of the month. With all other costs identical, if one lender were to provide an APR with an estimated closing date early in the month vs a lender showing an end of month closing date, the APR’s could vary considerably. Manipulating the closing date and the estimated interim interest is one of the easiest ways to reduce the APR figure. Estimating a close of escrow at the end of the month, rather than earlier in the month, will result in a more favorable (lower) APR calculation.
But, even this isn’t the worst part of trying to rely on the APR. There are two very bad assumptions that are assumed in every APR. First, the assumption that the value of a $1 today will be exactly the same 15 or 30 years from now (depending upon the term of your loan). Secondly, the APR calculation assumes that the loan will exist for the entire 15 or 30 year term. In other words, the homeowner will not move, refinance or prepay the loan . . . An unrealistic assumption in most cases.
The APR for Adjustable Rate Mortgages (ARM loans) is based on even more estimates and forecasts, making such calculations even less accurate.
So, while we don’t suggest that you ignore the APR calculation, we recommend that you compare the actual estimate of fees and points rather than relying upon the unreliable APR figure. Remember that every lender determines the “yield” they wish to acquire when placing any loan. This yield is a combination of the interest rate and fees charged. Simply put, this means that you can sometimes pay lessfees and accept a higher interest rate or pay more fees to acquire a lower interest rate.
Make sure you review the estimated cost sheet for any loan option and ask questions regarding any fee that you do not fully understand. Finally, there is probably no substitute for trusting your instincts when selecting the mortgage person with whom you decide to acquire your loan. You’ll soon recognize the mortgage lender who demonstrates a genuine desire to do that which is best for you, who takes the time to explain all of your loan options, provides the education you need to make good decisions and makes sure you understand the costs involved in borrowing money. That is the person you want to work with and you will not need an APR calculation to help you make your decision.