Annual Percentage Rate- Why is it Important?
Calculation of APR and the Difference Between APR and Note Rate
Aug 17, 2009
Shopping for a home mortgage is a tedious procedure and it is complicated by the fact that different lenders term for their fees by different names and comparison becomes difficult. Most borrowers simply compare the interest rates between different mortgages when they compare mortgages. A better rate of comparison is the Annual Percentage Rate or APR which takes in to account the fees charged by a lender in addition to the interest rate.
Lenders sometimes give lower interest rates to lure customers while at the same time having higher upfront fees. These may turn out to be costlier than loans which have higher interest rates and lower upfront fees. Since APR gives the true cost of borrowing, it is always better to compare the APR rates of lenders while comparing mortgages.
Difference Between APR and Interest Rate (Note Rate)
The interest rate or note rate is the percentage of loan amount that the lender is charging the borrower for borrowing money.The Annual Percentage Rate is calculated by adding the upfront fees and other origination fees of the loan to the interest costs of the loan and is then expressed as a yearly percentage of the loan amount. Since all the costs are considered, the APR will be a higher amount than the note rate.
Truth in Lending Act
The Truth in Lending Act(TILA) was enacted in 1968 to protect consumers from predatory and misleading practices of lenders and creditors. One of the provisions of TILA is that lenders must disclose the Annual Percentage Rate of the loan prominently on their advertisements. They are also required by the law to disclose the APR rates to prospective borrowers.
Annual Percentage Rate Calculation
Assume that a borrower is taking a loan for $100,000 at 6% interest rate and the total closing costs are $2000. In effect he is getting $100,000 minus $2000 which is $98000. By one year he has paid a total interest of $6000. As the effective loan amount is only $98000, the interest rate that he pays is actually 6.122% which is the Annual Percentage Rate of the loan. There are many online calculators available for calculating the APR.
Limitations of Using Annual Percentage Rate
- Some third party fees are excluded while calculating the APR. Home appraisal fees, home insurance and title fees are usually not taken into consideration when Annual Percentage Rate is calculated, but they usually add up to a significant amount.
- Comparison of APR is more useful for Fixed Rate Mortgages. Since the interest rate for Adjustable Rate Mortgages are not fixed, the Annual Percentage Rate that the lenders quote is not the actual figure and is based on forecasts.
- Annual Percentage Rate is calculated for the full term of the loan, but borrowers rarely keep a mortgage for 15 or 30 years. When a borrower refinance or sell a home after 5 or 7 years, a mortgage with higher upfront fees will end up being more expensive than a mortgage with low upfront fees and high interest rate.
- Calculation of APR varies from lender to lender. Sometimes lenders exclude some fees from the calculation of APR, so it is a good buyer to ask the lender about all the fees that are excluded.
APR gives a lender an easy tool to compare between different mortgages. While there is no fixed rule, an APR value of 0.25 to 0.5 higher than the interest rate is considered a reasonable figure. If the lender quotes a low interest rate but the APR value is way above the interest rate, look for a different lender because he is hiding his charges in the closing costs.
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