The Annual Percentage Rate, or APR, is perhaps one of the most misunderstood numbers in the mortgage process. Even some loan officers can misinterpret that the APR is for and why it’s needed but in this article we’ll talk about how to use it. The APR was first introduced back in 1974 as part of the original Consumer Credit Act of 1974 and applies to all forms of credit from credit cards to student loans to home loans.
The APR is simply explained as the cost of money borrowed expressed as an annual rate. When you take out a mortgage you also select an interest rate that goes along with it. That’s the note rate and the rate used to calculate monthly payments on a mortgage. The note rate and the APR are two separate pieces of data but you can’t calculate the APR without first having a note rate. In addition to the note rate there will also be finance fees needed to get that rate. These charges are those issued by the lender and third parties that are required. These fees go to offset the third party vendors for the costs of providing their service or documentation. For instance, when someone applies for a credit card, there might be an application fee involved. This fee must be taken into account when calculating the APR.
So, does the APR really matter? It does because it helps consumers compare offerings from different lenders. But there are plenty of loopholes consumers need to be aware of. The first is making sure the lender is correctly calculating the APR. Most software that lenders use already has the correct fees included in the application but other times the lender will provide the APR with a hand calculator. And federal regulations require that a lender report the APR each time they quote or advertise an interest rate. It’s not an option- it’s a requirement.
But here’s where it gets a little tricky. By assuming two different lenders know how to calculate the APR, it’s easy to look at both reported APRs and pick out the lowest one. But there are some other assumptions the lender makes. The first might be when you expect to close. Why is that important? Because prepaid interest is part of the APR calculation. When you buy a home and take out a mortgage, at your closing you’ll see a charge called “prepaid interest.” Prepaid interest is also included with your initial Loan Estimate or Good Faith Estimate. Prepaid interest is the daily accrual of interest up to the first of the following month. Mortgage interest is paid in arrears which means as each payment is made, the lender is paid interest for the previous month, not the upcoming one. It’s opposite of rent.
Okay, so if you close on the 15th, that would mean the lender will collect interest for the 15th, 16th, 17th and so on up until the first of the following month. Now consider someone who will close on the last day of the month and only one day of interest will be collected. Someone closing on the last day of the month will have a lower APR than someone closing on the 15th. Yet this could still be skewed because a lower APR with just one day of prepaid interest could also include higher lender fees. When you look at different APRs, make sure prepaid interest matches.
It’s also important to compare APRs on the same type of loan. When your lender quotes you a 30 year rate for example, you’ll also have different choices with regard to a particular rate for your selected loan program. A 30 year fixed rate loan and paying a discount point will have a lower note rate but could have a higher APR compared to a 30 year fixed rate loan with no points.
Confusing? It’s really not once you take these factors into consideration. Make sure you get the rate quote on the same day, get a quote for a specific loan program and ask for a loan with no discount points.
We can clear all this up for you and help identify the best loan program for your needs. Because we’re a mortgage broker and have working agreements with some of the top lenders in the country, let’s talk about which options would be best for you and let us shop around for your best deal. APR is important but once you start getting closer to locking down your loan, it’s a matter of rates and fees.