What is Annual Percentage Rate (APR)?

While not too many lenders, mortgage brokers, borrowers, government regulators and consumer advocate groups can agree on an exact definition of Annual Percentage Rate (APR), they can and do readily agree that the concept is a good one.

We will not be able to provide you with the exact definition. However, we hope to provide you with some lending industry history, a little bit on government intervention, a simplified example or two, as well as pointing out some minor weakness inherent in APR calculations, all in an effort to better educate you on this subject.

APR is the percentage representation of all credit related costs associated with consumer borrowing. The most significant of these credit costs is interest paid on a loan as determined by the borrowing rate or note rate (typically the advertised rate). It is not uncommon to see an advertised rate of 6.00% (borrowing rate or note rate) with an APR of 6.32% or more. It is the “other than” interest related credit costs that are responsible for the rate differential of .32%. So let’s learn what they are and how they impact the rate.

Many years ago when a homeowner sought a mortgage, it was common practice to visit the bank with which he/she normally did business and secure a mortgage there. Bankers welcomed these borrowers and discovered that they were almost always agreeable to accepting what ever rate was being offered. Since these borrowers were so willing to accept what bankers offered, the bankers became a bit overzealous and began charging additional fees for these loans. These additional fees were called points and represented a percentage of the loan amount (one point equals one percent). These fees eventually increased to where it was very common practice for bankers to charge two points, slowly leading to borrowers assuming that all loans cost two points.

Eventually, this practice became more of a concern to the government, not because of the additional charges but because proper disclosure was not being made to the borrower. To illustrate the government’s concern, let’s assume that a borrower received a mortgage with the following terms:

The government’s contention was that while the borrower had to repay the loan amount of $100,000, the lender actually loaned the borrower only $98,000.00 (Loan Amount $100,000 minus Loan Fees $2,000). The lender was well aware of it…..they only had to fund the $98,000 amount. The borrower was well aware of it….they only received $98,000. So what was the problem? The government was fine with the $98,000 loan amount but claimed that the 6.00% interest rate in the example above reflected a loan amount of $100,000, not $98,000. Hence, the 6.00% interest rate was incorrect. How can we be sure? Well, mathematically there are only four variables that impact a mortgage. They are:

If any one of these variables change with two variables remaining constant it forces the remaining variable to change. Let’s demonstrate this in a bunch of different ways. To begin, we will start with our earlier example:

Now let’s begin to change some variables and see what happens:

Remember our first example:

Well, the government said “Let’s hold the term and monthly payment constant (30 years & $599.55 per month), change the loan amount to $98,000 to reflect the actual dollars loaned (loan amount minus loan fees) and then determine what happens to the interest rate.” Here’s what happened:

In this example, the 6.189% is what the government says is the APR and needs to be properly disclosed to borrowers during the initial stages of the lending process. This lender disclosure was mandated by Congress in 1968 and became law with the passage of the Truth in Lending Act, which was part of the larger Consumer Protection Act.

The law went beyond just loan points in the APR calculations. They mandated that all loan costs must be included in the calculation and, when followed by all lenders, it provides the borrower with a valid basis for comparisons from lender to lender. However, the definition of loan costs often differs between lenders and as such the APR calculations would also differ between lenders, thereby reducing the validity of loan comparisons.

Generally speaking, the loan fees that are a part of the APR calculation are the following:

*(We generally agree with all of the above fees with the exception of Prepaid Interest. Prepaid Interest can impact the APR by as much as .10% depending upon when the loan funds during the month…..earlier in the month the higher APR, later in the month the lower APR. To learn more about Prepaid Interest, click here.)

Some fees incurred during the loan process that are occasionally included in the APR calculation are as follows:

Application Fee
Attorney Fees
Flood Certification Fee
Life Insurance Fee

Some fees incurred during the loan process that are not part of the APR calculation are as follows:

Appraisal Fee
Credit Report Fee
Escrow Fee
Title Insurance Fee
Notary Fees
Recording Fees
Taxes
Courier Fees
Misc. Title Company Fees

The inclusion or exclusion of certain fees clearly impacts the APR, as does the actual funding day of a loan in the case of prepaid interest. These are a few weaknesses within the APR calculation, but there are others as well.

Take for example a lender offering a borrower two loan programs, both of which have a loan amount of $100,000, have the exact same note rate of 6.50% and the exact same loan costs of $3,500 (Amt. Financed = $100,000 - $3,500 = $96,500), with the only difference being one has a 30 year term and the other has a 15 year term. See the APR calculations below:

Are you surprised? Should the APR’s be different at all? Should the APR’s be over .20% different? How does this help the borrower? These are all good questions. Our contention is that the APR comparison in this situation is not too meaningful. To be meaningful, you should be comparing loans with the same term so that the appropriate loan costs are recognized over that same period of time.

Another weakness within the APR calculations for comparison purposes relates to adjustable rate mortgages and intermediate adjustable rate mortgages. The issue is not with what loan costs should or should not be included in the calculation. Rather, the issue lies with the fact that the loan product type is tied to a fluctuating index such as the 11th District Cost of Funds, 1 yr Constant Maturity Treasury or LIBOR. Hence, there is no way to predict the future rate which is based on a fixed margin plus the variable index. So what is typically assumed by lenders in these types of APR calculations is a constant interest rate for the life of the loan based on the then existing rate. Let’s demonstrate this weakness by assuming a borrower receives an adjustable rate mortgage with the following terms:

Now, let’s further assume that three different borrowers received this exact same loan at three different times……say, January 1, 2000, January 1, 2002 and January 1, 2005. If it is the exact same loan, shouldn’t the APR’s be exactly the same? Let’s look.

Well then, how valuable is the APR? In this instance, not very. Then is it a joke? No, not really. Remember, when the government became involved in this matter in 1968, they mandated that the lenders fully disclose all loan costs to the borrowers via the APR calculation and disclosure. This is good. However, as you can see by the many examples above, there are many pitfalls in a total reliance on APR’s for loan comparison sake. So, a few tips for you to remember are:

1. When comparing APR’s make sure you are comparing apples to apples. A thirty year fixed rate to a thirty year fixed rate….Yes. A thirty year fixed rate to an adjustable rate loan……No.
   
2. Be sure to ask the lender or mortgage broker for a breakdown of those loan costs that are being included in the APR calculation. These are perhaps the most valuable numbers in valid loan comparisons.
   
3. While you are at it, make sure that the lender or mortgage broker provides you with a breakdown of all loan related costs, those that are included in the APR calculation as well as those not included. Often, this is the best comparison for the borrower.

   Last example, I promise.

   	THIS Lender	THAT Lender
   Loan Amount	$200,000	$200,000
   Interest Rate	6.50%	6.50%
   Term	30yrs	30yrs
   Monthly Payment	1,264.14	1,264.14
   Loan Fees:
   Included in APR	4,000	4,500
   Not Included	3,000	2,000
   Total Fees	7,000	6,500
   APR	6.695%	6.720%

THIS lender can provide you with the best APR, but THAT lender can give you the exact same loan with less fees but a higher APR. What’s the best deal? Now that you have been educated on this subject, we would like to hear your answer. Give us a call.

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