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Annual Percentage Rate (APR)

One of the most commonly asked questions is what is meant by the term “APR”?  As a consumer, you see it in advertisements and on certain loan documents. But what does this term really mean? And can it be used when you are shopping for a mortgage loan?

Background

The Truth-in-Lending Act (TILA) is a federal law that was enacted in order to better inform consumers on the cost of obtaining credit – car loans, mortgage loans, credit cards, etc. Prior to TILA, lenders were under no legal requirement to make full disclosure of the terms of a loan. As such, it was not uncommon for lenders to advertise loans with low interest rate but which included undisclosed fees and charges.

One of the key provisions of TILA was the requirement that a lender must disclose the “Annual Percentage Rate” (APR) of the loan when the lender advertises an interest rate. Also, after you have applied for a mortgage loan, the lender must provide you a “Truth-in-Lending Disclosure Statement” which discloses the APR for your specific loan. 

The calculation of the APR includes certain fees associated with a loan, thus informing consumers as to the “true” cost of a loan.   In theory, a consumer should be able to simply compare the APR offered by different lenders to determine which lender was offering the best deal. 

Unfortunately, what is good in theory does not always work in the real world.

APR Calculation

The best way to understand APR is by way of example.

Suppose I lend you $100,000 at a fixed interest rate of 8% to be repaid in 30 years with 360 equal monthly installments of $733.76.  The mortgage note will state a loan amount of $100,000, an interest rate of 8%, and 360 payments of $733.76.  If there are no fees on this loan, the APR will also be 8%. If we change the term of the loan, the APR will still be 8%. If we increase the loan amount, the APR will remain at 8%.

Let’s change the example such that everything stays the same except I charge you a fee of $1,000 to make the loan.  This fee can be an origination fee, discount points, or a combination of these and other fees.  By charging you a fee of $1,000 you are really receiving $99,000 (the $100,000 loan less the $1,000 fee). Under TILA, the calculation of the APR is based on the net loan amount of $99,000, which means that the $733.76 payment is cast over an effective loan amount of $99,000.  The interest rate on the loan is still 8%, but the APR in this example is 8.11%.

Suppose we increase the loan amount to $125,000 and keep all other items constant (i.e. amount of fee, interest rate, term). At the new loan amount the monthly payment will be of $917.21.  The interest rate is still 8%, but the APR would be 8.09%.  Accordingly, if the loan has fees and all other items remaining the same, increasing the loan amount decreases the APR, while lowering the loan amount would increase the APR. 

Another example, but a change in the term of the loan from 30 years to 15years.  At the loan amount of $100,000 there will be 180 payments of $955.65.  If there are no fees, the interest rate and APR will be 8%.  But with the $1,000 fee, the APR would be 8.17%.  Thus, if the loan has fees and all other items remaining the same, the shorter the term of the loan the higher the APR. 

Assume I agree to lower my fee to $500. With the loan amount of $100,000, interest rate of 8%, and 360 payments of $733.76, the APR would be 8.05%.  Thus, all other items remaining constant, the amount of the fee will impact the APR.  The less the fee, the lower the APR.

Adjustable Rate Mortgages

With every Adjustable Rate Mortgage (ARM), the interest rate is adjusted based on the margin and movements to the index, subject to whatever interest rate caps the loan might have. According to TILA, when calculating the APR on an ARM, a lender is required to assume that the index will not change. Thus, when a lender calculates the APR for an ARM it is advertising, it uses the index in effect on the day it advertises its rates.  And when calculating the APR for the TIL Disclosure Statement, the lender uses the index in effect on the day it prepares the Disclosure Statement.

Advertisements for ARMs must state that the rate may increase, or state that the rate is subject to change.  However, the advertisement need not explain how changes to the interest rate will be made.

APR and Fees

We know that fees impact the APR - with all other items remaining constant, the higher the fees the higher the APR.  The problem is that under TILA, not all fees are considered in the APR calculation.  For example, a loan origination fee is included in the APR calculation but an appraisal fee is not. An underwriting fee is included, but not title insurance. And so on. You still have to pay for these charges in order to obtain a loan, but they are not included in the calculation of APR.

There is a further complication due to the fact that TILA does not provide a complete list of what fees must be included in the APR calculation, but instead only provides a general overview.  This means that each lender has some latitude to decide which fees to include in the APR.  The result is that on the same loan different lenders can possibly calculate a different APR. 

APR - Fees and Interest Rates

Probably the most misleading item about APR is that the calculation assumes that a consumer will maintain their loan for the entire term of the loan. However, it is rare for a borrower to remain in a mortgage loan for the full term – usually they refinance, or buy a new home and sell their old home and payoff the mortgage. In fact, historical analysis has shown that the average consumer maintains their mortgage loan for 5 years.

To see how the APR can be misleading, suppose I give you the choice of borrowing the $100,000 at either an 8% rate and the $1,000 fee with the 360 payments of $733.76, or a 8.125% rate and a fee of $100 and 360 payments of $742.50. The APR for the 8% rate and $1,000 fee is 8.11%, and the APR for the 8.125% rate and $100 fee is 8.14%.

Most consumers would think that the 8% rate is a better deal because the APR is lower. However, this is only true provided you do not pay off the loan early. For example, if you were able to refinance and payoff the loan after 3 years, with the 8% rate you would have paid a total of $27,415.36 (36 payments of $733.76 plus the $1,000 fee).  With the 8.125% rate you would have paid $26,830 (36 payments of $742.50 plus $100), so the 8% rate was actually $585.36 more expensive, even though it had a lower APR.

Using APR

Because of the flaws with APR, we would suggest that you do not utilize the APR to determine the best deal on a mortgage loan. However, even with all the problems with TILA and the ARP calculation, the APR can still be a useful tool for an informed consumer. 

1.      As previously mentioned, under TILA every advertisement that contains an interest rate must also reflect the APR.  The term advertisement has a very broad definition under TILA and includes anything that is a commercial message regardless of how it is communicate (i.e. newspapers, magazines, radio, television, websites, mail, etc.).  Thus, if you see or hear a lender advertising an interest rate without APR, the lender is violating a federal law.  Needless to say, we would recommend you avoid a lender that is violating a federal law.

2.      When advertising an interest rate and APR, some lenders will set forth in the advertisement the assumptions they utilized for calculating the APR.  These assumptions usually include such items as the loan term, loan amount, downpayment, and loan type.  Although lenders are not required to list the assumptions, you should probably feel better about a lender that at least sets forth the assumptions it utilized to calculate the APR.

3.      If you see or hear an advertisement with what appears to be an unusually low interest rate, look at the APR.  What you will probably find is that the APR is substantially higher, which means that there are fees involved and/or that the loan is an Adjustable Rate Mortgage.

4.      In the examples we learned that when a loan has fees, the loan amount will impact the APR. Assuming the amount of the fees stay constant, the larger the loan amount the lower the APR. Lenders know this, so some lenders will calculate and advertise the APR based on a large loan amount. This is not illegal, but it could provide you with a misleading APR if the loan amount you are seeking is less than the loan amount utilized by the lender to calculate the APR.

5.      Due to the fact that the APR calculation assumes that you will maintain the loan for the full term, you learned that a loan with a low interest rate and high fees will produce a lower APR than a loan with a higher interest rate and lower fees. (But we also learned this may not be the best deal.)  In order to advertise low interest rates with a low APR, be aware that some lenders will advertise loans based on a low interest rate and high fees.

6.      If you are debating between a fixed rate loan and an ARM, using the APR is a fairly good and a reasonably easy way to compare (provided the fees are basically the same). However, since most consumers usually maintain their mortgage for only 5 years, using the APR as a comparison tool really only works for ARMs that have interest rate adjustments in the early years of the loan (i.e. 6 month ARM, 1 year ARM, 3/1 ARM).   

    

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