APR is an acronym for Annual Percentage Rate. The purpose of the mortgage APR is to inform the borrower during the home loan process that there are costs associated with a home loan beyond the interest paid with each payment.
APR is a combination of the interest rate, mortgage closing costs, and if applicable mortgage insurance, all converted into a one-year yield. The APR is not the mortgage interest rate. The amount of interest paid on a mortgage is a result of the actual interest rate, not the APR.
The APR’s true purpose is to help consumers shop and compare mortgage offers. In a perfect world borrowers would be able compare two APRs and determine which loan program has the overall lower costs. Unfortunately, the world is not perfect and this isn’t always the case.
APR vs. Interest Rate
The APR is supposed to be higher than the interest rate because it accounts for the fees. The only instance when the APR will equal the interest rate is when there are zero fees and it’s a “free” loan.
APR Calculation Explained
Here’s how to calculate the APR:
- First, determine the monthly principal and interest payment using the actual interest rate. You can use our mortgage payment calculators, a scientific calculator, or an Excel spreadsheet to determine the P&I payment.
- Next, subtract all APR fees from the loan amount. Let’s call this the “APR loan amount.” Note: you will not know the APR fees on your own. A mortgage lender would need to disclose the APR fees.
- Finally, using a scientific calculator or excel spreadsheet and solve for a new interest rate (the APR) using the P&I payment as PMT and the “APR loan amount” as the loan amount.
For example, a $300,000 loan with a 6% interest rate that is fixed for 30 years has a P&I monthly payment of $1,798.65. Let’s assume the loan has $3,000 of APR fees.
To calculate the APR we solve for an interest rate using the following: a monthly payment of $1,798.65, a loan amount of $297,000, a term of 360 months (12 x 30 years), and 0 (zero) for a future value. The APR is calculated to be 6.094%.
APR Can Be Misleading
There three major flaws that exists when comparing APR’s. First, APR calculations don’t consider credits toward closing costs. Second, the APR fees can vary from lender to lender. Finally, the calculation doesn’t consider variable interest rates.
Different loan programs can have different methods to pay for closing cost. This makes comparing APRs moot. For example, one loan program may have a slightly higher APR but offers a large lender credit. Even though the lender credit is absorbing a large amount of the costs, the APR calculations don’t take who’s paying those costs in to consideration.
Another flaw when comparing APRs from different lenders is that APR fees vary from lender to lender. As a result two identical Closing Disclosures (CD) from two lenders could have different APRs. This makes it difficult to compare apples to apples between lenders if one lender is including more fees in the calculation.
The final flaw with the APR, as if the previous two aren’t big enough, is that the APR isn’t truly accurate for Adjustable Rate Mortgages (ARMs). Because the monthly payment changes throughout the term of the loan the initial APR isn’t accurate for the life of the loan.
Ultimately the APR is meant to help you be an information consumer. Just realize that it’s an imperfect method to compare loan options. As always, you’re welcome to contact the Mortgage Mark Team with any questions.
Loan Officer, NMLS # 729612