What is the difference between the interest rate and the A.P.R.?

You’ll see an interest rate and an Annual Percentage Rate (APR) for each mortgage loan you see advertised. The easy answer to “why” is that federal law requires the lender to tell you both.  By showing both this can lead to confusion, especially to those First Time Homebuyers.

The Federal Reserve wants the APR to be a tool for comparing different loans, which will include different interest rates but also different points, fees, and other terms. The APR is designed to represent the “true cost of a loan” to the borrower, expressed in the form of a yearly rate. The problem is that there are many costs associated with a loan, that are not considered in APR.

What Fees Are Included In The APR?

• Loan Origination Fee
• Loan Discount Fee
• Other Lender/Broker Fees (Application, Underwriting, Processing, Tax Service Fee, etc.) – Anything paid to the broker or lender or affiliate of the broker or lender
• Odd Days Interest
• Mortgage Insurance Premium
• Title Closing Fee

While APR was designed as an attempt to make it easier to compare loans, it’s sometimes confusing because the APR includes some, but not all, of the  costs associated with a mortgage. And since the federal law that requires lenders to disclose the APR does not specifically declare what goes into the calculation, APR’s can vary from lender to lender and loan to loan.

What Fees Are Not Included In The APR Calculation

• Escrow Setup
• Appraisal Fee
• Title Insurance

Let’s Throw Adjustable Rate Mortgages In The Mix

The APR on an Adjustable Rate Mortgage (ARM), a loan tied to a financial index, like a 5/1 ARM, assumes the index will never change. The interest rate on an ARM is composed of the index and margin.  Because of the underlying assumption that the index will not move over the life of the loan, the APR can be grossly under or over stated on an ARM depending upon if the index moves up or down over the life of the mortgage.  ARM’s loans were created because the Bank does not have to assume the interest rate risk of a Fixed 30 Year Mortgage, allowing the consumer to get a slightly lower rate, and assume the risk that rates will rise.  These financial indexes have always moved over the course of a 30 year mortgage thus making the APR a difficult tool to compare a fixed rate mortgage to an ARM.

So, APR’s are at best inexact. The lesson is that APR can be a guide, but you need a mortgage professional to help you find the truly best loan for you.

Show What Should You Do?

You as a consumer need to look at two things when considering a mortgage loan

• The front end costs associated with obtaining the loan, not just those deemed pre-paid finance charges, and thus included in the APR calculation
• The interest rate, and the total cost of the loan over time.

Here is a Comparison of two different mortgages, both 30 year fixed rate mortgage.

The first mortgage has an APR of 5.03%, and the 2nd has an APR of 5.25%.  So, if you were to choose a loan simply based on the APR the typical choice would be the 1st mortgage; however, if you will be staying in the home less than 90 months (most loans are only held for 60 months) then the best choice is Loan 2, because the total cost is cheaper.

Make sure you are dealing with a mortgage professional that doesn’t just throw rates and fees at you over the phone. I’ll take the time to prepare a total cost illustration and determine that the loan you select meets your long term objective.

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