If your lender calculated the APR properly, there really isn’t much difference. But for consumers not really familiar with the term “annual percentage rate” or APR, it can cause a bit of confusion. And unfortunately, many loan officers aren’t really clear on the differences or even able to explain what APR is and why it’s different than the note rate. We know the differences and we can explain it clearly for you.
The APR became a required number when the federal Truth in Lending ACT (TILA) was implemented in 1968, designed to assist consumers more clearly understand the use of credit and associated costs, both long and short term, of obtaining credit. The APR is the cost of money borrowed expressed as an annual rate. Unfortunately, it often times creates more confusion than clarity.
The note rate is the actual interest rate used to calculate a monthly payment. The APR is used to compare the cost of money borrowed from that particular lender on a specific transaction. All companies who issue credit from automobile loans to credit cards to mortgages are required to show the APR any time an interest rate or loan offering is advertised. For example, let’s look at a 30 year fixed rate loan with a 3.50% note rate on a $300,000 loan. The interest rate is $1,347. The APR has nothing to do with your mortgage payment. Both have different purposes. The note rate is the rate you locked in and used to calculate your monthly principal and interest payment to your lender. The APR is used as an attempt to easily provide a way to evaluate additional costs needed in order to get the mortgage. If the closing costs in this example added up to $5,000, the APR would be 3.63%. We’ll get into the calculation later in this article.
How APR Should Be Used
Used properly, the APR should be used to compare the very same loan option from one lender to the other. But that’s where some of the confusion begins. You can’t compare the APR on a 15-year loan with the APR on a 30-year loan. The comparison has to be the same term, rate, and loan amount. And ideally, the comparison should be on the same day and even as close to the same time of day as possible. Why? Because rates can change from day to day and during extremely volatile times even during the course of a business day. If you get an APR from one lender on Monday and one from another on Wednesday you might not be getting the true picture because the note rates may have changed.
Okay, now let’s do all that together and get that same $300,000 quote from a lender at 3.50% on a 30-year loan. Lender A had $5,000 in closing costs and the resulting APR was 3.63%, using the example above. Now let’s say Lender B also quoted the same scenario and the APR worked out to be 3.60% due to Lender B’s lower closing costs of $4,000. If consumers solely used the APR to compare the best loan option, Lender B would win.
Let’s look at another example, this time with a 15-year loan on $200,000 at 3.00%. The principal and interest payment on this loan is $1,381. Lender A has closing costs of $5,000 and Lender B has $4,000. The APRs respectively are 3.36% and 3.29%. Lender B has the same note rate but with lower costs than Lender B.
Which types of costs are included in the APR calculation? Perhaps surprisingly not all of the fees are lender fees but additional fees for services lenders require to close your loan. Common fees included in the APR calculation are:
- Discount Points
- Origination Fees
- Loan Processing Fee
- Underwriting Fee
- Document Fee
- Appraisal Review
- Mortgage Insurance
- Application Fee
- Document Preparation
- Prepaid Interest
Common fees not included in the calculation are credit report fees, appraisal or survey, inspection fee, flood, title search, title insurance, recording fee, hazard insurance, impound accounts and others not mentioned above.
If you’re wondering why some fees are included and some are not, you’re not alone asking that question. In reality, all charges should be considered because they are a cost of obtaining credit but they’re not. That’s something else that can be a real head-scratcher.
One thing that you might notice here but it bears pointing out. The APR and the note rate can never be exactly the same. You may have seen credit advertisements that claim, “3.50% APR and Note Rate.” Even if there were no closing costs at all, because Prepaid Interest is part of the calculation, the APR has to be higher. When you close on a purchase, the lender collects per diem interest up to the first of the following month, which is essentially your first payment. If you close on the last day of the month and the lender collects just one day of prepaid interest, that amount will be used to calculate the APR. An imperceptible difference, granted. But a difference nonetheless.
When you receive your loan disclosures and documents and you see your APR number, certainly take that into consideration but remember it’s not the rate your monthly payment is based upon. The creation of the APR was made because some creditors began a habit of charging a higher price for an item reducing or providing a credit for certain loan fees. Think of a new car financed with a 0.0% interest rate over five years. Do you think the new car costs just a little more because of the reduced fees?
The APRs attempt to clarify the cost of money borrowed is a noble effort but unfortunately, it falls short of doing so. If you have any further questions about APR or want more information, give us a call and we’ll prepare a custom quote for you.
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