By Keith Loria
If you’re in the process of shopping for a mortgage or considering refinancing, you’ve probably run across the term annual percentage rate (APR) more times than you can count. But what exactly is an annual percentage rate, and how can it help you when you’re looking to buy a home?
In its simplest terms, the APR represents the “true cost of the loan” by factoring in the cost of loan fees amortized over the life of the loan. The APR was created to let mortgage shoppers compare different loans with the same interest rates in order to establish which mortgage is best for their particular needs.
When you apply for a mortgage, the lender will send you a Good Faith Estimate and a Truth in Lending statement within three business days, which will include the note and the APR. The APR is calculated based on a formula determined by the government. The Truth in Lending Act requires lenders to disclose the APR of a loan at closing.
Calculating the APR on a fixed-rate loan is a simple formula to figure out, as long as you know the interest rate, loan term and loan-related fees (points, pre-paid interest, loan-processing, underwriting, loan document preparation and PMI). First, add up the loan amount plus all loan-related fees to determine the adjusted balance, then calculate the monthly payment on the adjusted balance with the interest rate.
For example, one lender might offer a 30-year fixed-rate mortgage for $150,000 at 4.5 percent interest and $5,000 in fees, while a second lender offers the same mortgage for 4.25 percent interest and $7,000 in fees. While the up-front costs of the first loan are lower, the second lender’s loan will actually cost less in the long run.
Finding the APR on adjustable-rate mortgages is a little more complicated because the rate on these mortgages can change after the fixed-rate period expires. To get the closest estimation, lenders use the fully indexed rate (to calculate APR for the adjustable period instead of the stated rate).
Remember, the APR is an artificial measurement of the relative cost of the loan transaction. It doesn’t have a bearing on the actual rate of interest on a particular loan, but it does take the rate of interest into account. The APR will always be higher than the note rate you were originally quoted, so don’t be surprised if the numbers aren’t exactly what you expected.
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Reprinted with permission from RISMedia. ©2014. All rights reserved.