Annual Percentage Rate is an Imaginary Interest Rate
It is not used to calculate payments. If some of the closing costs were spread out over the life of the mortgage, what would an interest rate have to be to cover those fees and the real interest rate?
…It’s the APR.
The APR is higher than the interest rate because it takes into account some of the costs paid when getting a mortgage.
The following fees are usually, but not always included in the APR:
- Discount Points, and Origination Fees
- Interest paid early, or on time, or late. 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, I am allowed to use any number between 1 and 30
- Loan processing fee
- Underwriting fee
- Document preparation fee
- Private mortgage insurance (PMI)
- Appraisal fee
- Credit report fee
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 not usually 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
So, mortgage companies can make the APR seem lower or higher by choosing which items to include in the calculation. Note: You may also choose to examine the HP12C calculator handbook for APR calculations.
How to Calculate APR
Note: You may also choose to examine the HP12C calculator handbook for APR calculations.
Reduce the loan amount by some of the closing costs, and then calculate the interest rate needed to generate the actual monthly payment (using the artificially reduced loan amount).
Instead of paying closing costs what if most of these costs were included in the real interest rate? What would the interest rate have to be in order to account for these additional expenses? It would be higher. That’s the APR.
Increase the loan amount by adding the close some of the closing costs. Use the real interest rate and the increased loan amount to calculate a falsely higher principal and interest payment.
Use the higher P & I (from #2) and the real, original loan amount to calculate the new artificial interest rate that will be disclosed as the APR (annual percentage rate).
Examples of Confusion Caused by Using APR
- For a one year adjustable rate mortgage (ARM) whose initial rate is 4.5%, the APR can be estimated to be 8.3% for a $150,000 loan amount and 8.7% for a $50,000 loan whose closing costs are $1000 less.
- For a $150,000 loan at a fixed rate of 7% and closing costs of $2500 the APR is estimated to be 7.16% or 7.66% the difference depends on how private mortgage insurance (PMI) is calculated.
An APR does not tell you if your rate is locked for 12 days or 180 days. If you choose a 12-day rate lock, it will have a lower APR than the same interest rate locked for 60 days.
Calculating APRs on adjustable and balloon loans is even more complex, because the future rates are unknown.
It is not useful 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.