APR Explained
Posted by: Greg Fischer Post date: July 12th, 2011When you apply for a new mortgage, one of the disclosures that you’re given is the Truth In Lending. This document discloses your Annual Percentage Rate (APR) among other things. It is a disclosure required by the Fed on ALL residential mortgage transactions to help you – the consumer – compare loans from different lenders. It is also one of the least understood forms, and APR is one of the least understood items in a mortgage application.
APR is designed to show you the “effective” cost of the money you are borrowing. It is NOT your interest rate. In almost all cases, it’s a higher number than your interest rate. What it does is take the total cost of interest, mortgage insurance, and certain loan closing costs over the full term of your loan (usually 30 years) and divides them back in a formula that describes the total cost.
In theory, if you were comparing 2 otherwise identical loans, the loan with the higher APR has the higher cost. But like many other mortgage figures, the APR is a number that is influenced by a number of other factors. Comparing multiple loans using only the APR is apt to show results that aren’t quite what you expect.
For instance, a loan with 1 point and a lower interest rate will have a lower APR over 30 years (you spent $2000 at closing for a lower interest rate that over 30 years saved you $20,000), but that lower rate still has a higher cost at closing. If you plan to be in the loan long term, you will save money. But over the first few years, the savings doesn’t equal the cost. So over 4 years, the “cheaper” loan with the low APR is actually more expensive.
The solution? Look at the APR. It does matter. But also know what the interest rate and total non-recurring closing costs are (like underwriting, title, processing etc). If one loan costs more actual dollars, it might still make sense in your situation. Ask. Get answers. Ask until you understand what happens between different rates and fees. Then compare. That way, you’ll understand what you’re getting, even if the final APR calculation still seems a bit unclear.
