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.

Example: 30-year fixed 8% 1 point 8.107% APR

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

If life were easy, all you would have to do is compare APRs from the lenders/brokers you are working with, then pick the easiest one and you would have the right loan. Right? Wrong!

Unfortunately, different lenders calculate APRs differently! So a loan with a lower APR is not necessarily a better rate. The best way to compare loans in the author's opinion is to ask lenders to provide you with a good-faith estimate of their costs on the same type of program (e.g. 30-year fixed) at the same interest rate. Then delete all fees that are independent of the loan such as homeowners insurance, title fees, escrow fees, attorney fees, etc. Now add up all the loan fees. 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 APR are not clearly defined.

What fees are included in the APR?

The following fees ARE generally 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!
Loan-processing fee
Underwriting fee
Document-preparation fee
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
An APR does not tell you how long your rate is locked for. A lender who offers you a 10-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. The result is even more confusion about how lenders calculate APRs.

Do not 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 their APRs. It is quite possible that the same lender with the same fees using two different software programs may arrive at two different APRs!

In Conclusion :
Use the APR as a starting point to compare loans. The 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.

The effective rate of interest for a loan per year - same as Yield to Maturity

Text book example:

Abel gets a loan for $50,000 at 10% interest plus two discount points payable over 30 years. Because of the discount points ($500 per point = $1K) $49,000 has been effectively borrowed but $50k must be repaid at 10% interest on $50k. Considering the effective amount borrowed, the annual percentage rate is 10.25%. The same would apply to any closing costs that are financed as part of the loan. In other words, say the $1k was closing costs, the interest rate is figured on the gross loan amount of $50k, however, since only $49k was what was actually borrowed the APR is higher than the interest rate because you are paying your full payment to amortize the $50k over 30 years when you actually received funds for $49k so that changes the APR essentially because it gives you the interest paid on an annual basis on your actual borrowed funds ($49K). It simply provides the customer with a breakdown of what they are actually paying (regarding interest rate) on the actual funds that they borrowed. The amount that they borrow does NOT include the closing costs or other fees paid to 3rd parties as part of the loan transaction.

Another sample...

let's look at a 90k loan at 7% interest. The loan amount (including all closing costs that are part of the transaction) is $90K. The interest rate on the 90K is 7.0%. The closing costs total $4,125.00 The Amount Financed for, Truth in Lending purposes, (the actual amount the borrowers borrowed) is $85,875.00 (90k -4125.00 = 85,875) The borrowers are paying back on a $90K loan (the total of AF + closing costs) over a period of 30 years at 7% interest, however, when you take into consideration the actual amount they borrowed (85,875) and use the same payments over 360 months (which is 598.77 + 1 payment of $601.62) the total that they repay is $215,560.05 over the life of the loan. Therefore the actual cost of the money that they actually borrowed (85,875) on an annual basis is 7.471% which is the effective cost of the credit on an annual basis. It simply gives the consumer a different (not necessarily better) picture of how much they are actually paying in interest on an annual basis on their net loan not including closing costs. As far as the lender is concerned the customer is paying the full amount borrowed (90K) over the term of the loan that is why the interest rate is 7% (lower than the APR), but the actual funds that the borrower had the use of is 85,875 which at the same term/payment makes the realized interest rate higher (less money with same payment). Top of Page