How Does the APR Calculation Help a Homebuyer?

One of the most confusing aspects of shopping for a mortgage is to understand the differences between the annual percentage rate (APR) and the actual interest rate of a mortgage. The interest rate is the actual charge incurred for borrowing the money, but it is not the only costs associated with obtaining a mortgage. The APR measures the total costs associated with the mortgage, it is also referred to as the effective interest rate paid on the mortgage. It includes the interest expense, as well as one-time fees, such as: closing costs, points, etc. The costs to obtain a mortgage can differ by lenders and loan products, such as: fixed, variable, balloon, etc. Since the APR is an all-encompassing calculation, it is always higher than the actual interest rate charged. Therefore, the APR is a true representation of the total costs to obtain a mortgage. One of the main reasons and advantages of the APR calculation is for comparison to other mortgages. A homebuyer can gauge the amount of closing costs being charged on a mortgage by comparing the difference between the interest rate and APR. The farther the interest rate and APR are apart, disclosures that there are greater costs associated with the mortgage.

Below is an example of an APR calculation:

In this example, we are using a $100,000 mortgage with a 4% 30 year fixed rate. Based on the interest rate, the annual interest charged would be $4000 (4% x 100,000). For the APR calculation, the other charges associated with the mortgage would have to be included. These other costs include: bank fees, the mortgage insurance premium, and points. For this example, let's assume the total other costs are $3000. To calculate the APR, you would add the other costs ($3000) to the initial mortgaged amount ($100,000). Then you would multiply the interest rate (4%) by the total amount ($103,000), which equals $4120 annually. You would then divide the above calculation by the original mortgaged amount (4120/100,000). The result is an APR of 4.12%.

The APR calculation is different for an adjustable rate mortgage, because the APR does not reflect the maximum interest rate possible. The APR calculation is just one tool in determining if the mortgage offered is the best option for you.

Below are the fees included in the APR calculation:

• Origination Fee and Points - These fees are additional money paid upfront to reduce the initial or permanent interest rate.

• Bank Fees - These include fees listed on the good-faith estimate, such as: underwriting, lock-in, processing, doc prep, commitment, and administration.

• Title Fees - Only certain title fees are added to the APR calculation, these include: title insurance, attorney's fees, and various other fees.

• Mortgage Insurance Premium - This is an additional fee that a borrower pays to insure the loan against default.

• Pre-Paid Interest - This is the interest that is paid from the date of closing till the end of the month.

The APR calculation does not include all fees associated with obtaining a mortgage. The loan application and tax service fees may or may not be included in the calculation. The following fees are typically not included: title, recording, appraisal, and credit report.

Just remember, when shopping for a mortgage the APR is just one comparison tool that you can use. Ask for and thoroughly compare each good-faith estimate from the lenders you are considering using for your mortgage. The good-faith estimate should clearly disclose any bank fees being charged for the loan. Using the APR, interest rate, and comparing bank fees charged by each lender will help you secure the best mortgage option available.

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