APR Explained in Everyday Language

Annual Percentage Rate (APR) Explained in Everyday Language

Annual Percentage Rate (APR) Explained

There’s quite a bit of information disclosed when you first submit a loan application. You’ll be asked to provide documentation supporting how much money you make each month, how much you’ve made the last two years, how much available cash you have on hand to close a transaction…and that’s just the beginning. Once an application is submitted, that action automatically triggers the disclosure of various facets of the loan you’re looking at. Some of these documents are of less importance than others but still needed nonetheless. One of the disclosures that earns the most scrutiny is the Loan Estimate, formerly referred to as the Good Faith Estimate.

How the Annual Percentage Rate (APR) is Calculated

It’s on the Loan Estimate where various charges are itemized. There are lender charges and non-lender charges and many of these charges directly affect the Annual Percentage Rate (APR). When borrowers first review this estimate the one thing most automatically noticed is the Annual Percentage Rate (APR), prominently listed. Yet what can surprise many is the APR is higher than the note rate on the actual mortgage. This can lead to someone thinking what they were told and what they were getting are two different things entirely. This misunderstanding is usually the result of an inexperienced loan officer not explaining important aspects of the loan.

The Annual Percentage Rate (APR) can be confusing at first and even some loan officers can’t accurately explain it to a borrower in everyday language. Some might even say the APR isn’t really important anyway and to ignore the APR. But that would be a mistake. It’s important to understand the APR and why it matters. Simply and accurately put, the APR is the cost of money borrowed expressed as an annual rate. That’s it.

Lenders with higher associated loan costs will have a higher Annual Percentage Rate (APR) compared to another with lower costs. The APR is calculated by considering the interest rate on the selected loan, discount points paid (if any), interest and lender and most non-lender fees.

How it Works

For example, let’s say the interest rate on a mortgage is 3.00%. That’s what the monthly payments will be based upon as well as the term of the loan. If there are $3,000 worth of additional charges, then the cost of getting that loan is 3.00% plus $3,000, right? The Annual Percentage Rate (APR) will factor in those $3,000 worth of charges to arrive at the disclosed number. Common loan fees included in the APR number are discount points, loan processing fee, underwriting, document preparation and even private mortgage insurance among others.

The higher the lender fees, the greater the disparity between the interest rate on the loan and the resulting Annual Percentage Rate (APR). If the note rate is 3.00% with a 3.05% APR, the loan fees are lower compared to an APR of 3.25%. Interest is also factored in and why the APR will be higher for someone buying and closing on a home on the last day of the month.

Why? Because the last day of the month will have just one day of interest factored in. Someone closing on the 15th will have 15 days of prepaid interest and therefore a slightly higher APR. This is why the Annual Percentage Rate (APR)  can change from the initial disclosure to the final closing because the initial APR number was based upon an estimated close date compared to the actual one.

What’s Next

The purpose of the Annual Percentage Rate (APR) disclosure is to help consumers best determine the ideal loan choice but without proper understanding of APR and where it comes from, it can lead to a confusing scenario. That’s why I spend so much time going over rates and fees with you so you’ll be clear about which loan scenario is best for you.