What is the Annual Percentage Rate and Why Is It So Important?
If you want to compare loan offers side-by-side, you’ll need to pay close attention to three items: the interest rate, the lender’s breakdown of loan fees, and the Annual Percentage Rate (APR), say the experts.
The most important loan term is the interest rate, which is the rate you’ll be charged for borrowing the money. It’s a single number that does not reflect the lender’s fees or any other costs associated with the loan.
The APR is a broader measure of the cost of borrowing the money, reflecting not only the interest rate you’ll be paying, but also some of the other fees you’ll be charged for the loan (more on this later).
How APR is Calculated
Lenders calculate APR by adding their fees for the loan into the interest rate. This is done by amortizing the fees out over the life of the loan as if they were additional payments, and then calculating a new rate, explains Nate Moch, group manager for Zillow’s Mortgage Marketplace.
The disclosure of the APR is mandated by the Truth in Lending Act, or TILA, to help you understand the tradeoff you’re making between paying a higher interest rate for the loan and fewer upfront fees, or paying upfront fees such as points, or prepaid interest (one point equals 1 percent of the value of the loan), to secure a lower interest rate.
The APR is most useful for borrowers shopping for a fixed-rate mortgage, doing a cash-out refinance, or a low- or no-cost mortgage who expect to hold the mortgage a long time.
The APR of adjustable-rate loans does not reflect the maximum interest rate of the loan, notes the Consumer Financial Protection Bureau. So be careful when comparing the APRs of fixed-rate loans with adjustable-rate loans, or among different adjustable-rate loans. The APR is calculated somewhat differently for different loan types, so it’s best to only compare APRs across similar products.
Between the Lines
Don’t just use the APR to select your loan.
While the fees for your loan are paid upfront, the APR calculation assumes that the fees will be paid over the life of the mortgage in the same manner as the interest. Since most borrowers do not keep their loan for the full period (they typically refinance or move), the APR can make some loans look artificially better, says Jack M. Guttentag – a.k.a., The Mortgage Professor, a nationally syndicated columnist and Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania.
Determining which fees go into an APR can be a complicated task for a lender, more art than science. As a result, it’s possible for two loans to have the same interest rate and fees, but different APRs depending on what fees the lender includes in the calculation.
To look at the fees side by side, you’ll need to compare the interest rate, the APR, and the costs to make sure it’s an apples-to-apples match. “If it appears that everything about the loans is the same except the APR, ask the loan officer why the APR is different,” says John Downs, a mortgage officer with Caliber Home Loans in Washington, D.C.
“You shouldn’t choose a loan based on the APR alone, but how well the lender explains all of the loan terms, and how comfortable you are doing business with that lender,” Downs says.
(Editor’s note: this article originally appeared in The Home Story on Feb. 27, 2015.)