What is the APR (Annual Percentage Rate) of a mortgage loan?
The annual percentage rate (APR) is an interest rate that is different from the note rate. It is 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 7% 1 point 7.307% APR
The APR does NOT affect the monthly payments. The monthly payments are calculated from the interest rate and the length of the loan. BUT it DOES affect the TRUE rate of interest paid on the cash the borrower actually RECEIVES.
The APR can be a very confusing number! The APR is designed to measure the "true cost of a loan." It is intended to create a level playing field for lenders and prevent lenders from advertising a low rate and hiding fees.
THE APR is the True Interest Rate you are Paid on the Money Receive by the Borrower after Certain Fees have been Deducted
That is to say, you take the loan you are going to be paying interest on, subtract the Prepaid Finance Charges and recalculate the interest rate.
Regulation Z of the Federal Truth in Lending law states that all Prepaid Finance Charges are to be considered and included in the calculation of the APR of a loan.
But which costs are considered Prepaid Finance Charges? The following lists what Regulation Z considers as Prepaid Finance Charges in calculating the APR. While this list is not all-inclusive, it does list those loan costs that should be included and mortgage brokers and lenders would generally include on a Good Faith Estimates for residential mortgage loans.
Prepaid Finance Charges:
- Origination Fee and Points on the loan
- Discount Fee
- Processing Fee (by mortgage broker)
- Underwriting Fee & Other Fees by the wholesale lender
- Tax Service (also normally charged by the lender)
- Flood Certification (this fee is also usually charged by the lender)
- Interest Adjustment (Prepaid Interest on the new loan)
- Upfront Private Mortgage Insurance Premium (if required)
- Reserves (Monthly) for PMI or MIP (if required)
- Closing/Escrow Fee
- Wire/Messenger Fees
By contrast the following closing costs are not included in calculating the APR. While not all-inclusive, it lists the loan costs normally found on Good Faith Estimates
Non-Prepaid Finance Charges:
- Credit Report Fee
- Appraisal
- Title Insurance
- Hazard (Property) Insurance
- Property Taxes (paid or impounds for reserves)
- Recording Fees
Regulation Z also requires (and expects) that the fees and charges for those services provided and listed above (and on the Good Faith Estimate, GFE) should be reasonable and common for that area in which the loan is being done. (Note, many of these fees are commonly regarded as "garbage fees".) Here's an example: Total loan amount $100,000
Prepaid finance charges
- Origination Fee (2.0%) $2,000.00
- Processing Fee: $325.00
- Underwriting Fee $450.00
- Settlement or Closing/Escrow Fee $325.00
- Wire Transfer Fee $25.00
- Flood Certification Fee $15.00
- Tax Service $75.00
- Interest Adjustment (Pre-Paid) $203.12
- TOTAL $3,418.12
Calculation of the APR
Calculation of the APR of a loan is a 4-step process.
1. Itemization of the Loan Amount of $__________.: - This is the total amount of the loan. Enter $100,000.
2. Total Prepaid Finance Charge (Amount Paid to Others on Your Behalf): - In this step we enter the actual amount of each Prepaid Finance Charge shown on your GFE or that you estimate (at that time) the customer would incur based on an interest rate you may have quoted. Adding together all of the above Prepaid Finance Charges come to $3,418.12.
3. The Amount Financed: $_______________ - Now subtract the (total) Prepaid Finance Charge from the Total Loan Amount = ($100,000 - $3,418.12) = $96,581.88. That figure ($96,581.88) is called The Amount Financed . Now you can calculate the APR with your financial calculator. Or use the financial calculator we have free on-line. Clear all the registers in it.
4. APR Calculation: - Enter the figures and amounts in the calculator you would normally do to calculate the monthly P&I on a loan (assume a 30-Year fixed rate @ 6.5%). Thus Present Value = $100,000, Interest Rate = 6.5%, Total # of payments = 360 (30 years) and compute the Payment Amount. Which = $632.07. Next, enter the Amount Financed ($96,581.88 in the example above) - as the PV (Present Value) on your calculator. Do not change any of the other figures. Now solve for the Interest Rate. If using our calculator or one that shows the annual rate of interest, then the Interest Rate you show is the APR. (If your calculator presents the interest rates in monthly terms - then multiply that figure by 12.)If you have correctly gone through the steps above - then you should have calculated an APR of 6.84%. The APR on a fixed-rate mortgage will always be higher than the Note Rate on that loan. The only exception to this would be a “No Cost” loan. Then the APR could be the same or slightly higher than the Note Rate. Remember there is a relationship between the APR on a mortgage and the total Prepaid Finance Charges. As the Prepaid Finance Charges increase, the APR gets higher over the Note Rate (because more costs are included on the loan).
