APR is short for annual percentage rate. It's a formula that considers some of the costs of acquiring a loan along with the actual rate of the loan, then translates those costs into the equivalent rate for a loan without those costs. It's an attempt to provide a standard for comparison. However, borrowers who use APR as a basis for a loan decision without fully understanding APR frequently make a less-than-optimum decision.
There is a lot of talk in the industry about annual percentage rate (APR). In fact, APR is a required disclosure on many advertisements. While most people have a vague understanding of APR, few fully understand the concept; yet many make decisions based on it. This is one of those subjects where a little information can be counterproductive. Many people make decisions–bad decisions–using a tool they don't really understand.
This isn't a course in mathematics, and it won't make you an expert in APR, but it will give you the working understanding to make an informed decision. You'll know when to use APR and you'll understand when APR can lead you astray.
The basic concept of APR was to create a basis for comparing loans. Since different lenders quote an endless variety of rate, point and fee options, the government felt too many consumers were unable to determine the overall best value. Admittedly, it's not easy to make comparisons, but APR can be useful if used cautiously.
The APR calculation effectively takes the discount points and SOME of the fees associated with acquiring a loan and converts those expenses into a corresponding rate adjustment. The actual rate of the loan is then adjusted upward to reflect the rate of a theoretical loan with the same payments, but without the associated discount points and fees. (If there were no fees or points, the APR and the actual note rate [interest rate] would be the same.)
Here's another way to look at it. Suppose you want to borrow $100,000. You choose a 30-year fixed rate loan at 7.5%, and pay one discount point ($1,000), a 1% origination fee ($1,000), and $350 in other fees. Although the lender is giving you a loan for $100,000, you have paid $2,350 to the lender. Your payments are based on a loan of $100,000, but your net proceeds are only $97,650. Hence your APR is 7.75%. In other words, if you selected a rate of 7.75% and did NOT pay the discount point, the origination fee, or the $350 in other fees, the APR says you would have the same overall value as the 7.5% loan with the $2,350 in expenses.
There are substantial limitations to the APR. In the previous example it was noted that the two loans (7.5% with $2,350 in expenses and the 7.75% with no expenses) were the same value with respect to the APR. However, the APR assumes both loans go to the full term. If the loan is paid off in five to seven years (the average life of a mortgage), the two loans are NOT the same value. The higher-rate loan is the better value. Suppose the borrower with the 7.5% loan sells the house in five years. That borrower has made 60 payments of $694.87 plus the initial expenses ($2,350) for a total of $44,042.20. The borrower with the 7.75% loan has made sixty payments of $711.82 with no initial expenses for a total of $42,709.20. The higher-rate loan costs $1,333 LESS than the lower rate loan. Clearly, in this case using APR to make a decision would be unwise. There are similar cases when a loan with the lower APR may actually cost the borrower more when all factors are considered.
You should also be aware that not all lenders follow the rules of calculating APR under the Truth in Lending Act. For example, the application fee may or may not be included in the APR calculation, depending on how the lender conducts business. Yet the actual fees that are included in the APR do not have to be separately disclosed. One lender may offer an incredibly low rate and show a very low APR because the loan has been packaged to avoid including substantial fees in the APR calculation. Ask to see a breakdown of fees charged.
Still another shortcoming of the APR is its understandable failure to recognize the "opportunity cost" of the discount points used to buy down the rate. For a savvy investor getting high rates of return, it's typically not warranted to reduce investments for a slightly lower rate on a mortgage.
For adjustable rate mortgages (ARMs), the APR is based on the "accrual rate" of the loan, which assumes the loan rate will make adjustments based on the current index and margin for the loan and other adjustment restrictions. Of course, economic conditions are likely to change, so the actual APR will probably be different. Many software programs used by lending institutions rely on the person generating the quote to enter the current ARM index and margin. Be careful that your ARM quote doesn't use an inaccurately low index. In fact, you should ask the lender what index and margin was used for the quote.
Borrowers can use APR for a quick analysis of a loan proposal. For example, if a lender quotes a rate well below the market rate, but the APR is substantially higher, the borrower can assume the loan requires payment of high fees. As mentioned previously, however, some fees may not be included in the APR, so this "quick check" isn't foolproof.
Borrowers can avoid the pitfalls of APR by following a few simple steps:
- Determine the estimated time period you expect to have the loan (e.g., five years)
- Determine all the costs associated with the loan acquisition (exclude any prepaid taxes and insurance).
- Determine the total interest and mortgage insurance that will be paid for the time you think you will own your home. If you have difficulty with that calculation, just use the total principal and interest (P&I) payments plus the mortgage insurance and your comparison will be reasonably accurate.
- Add Nos. 2 and 3 and select the lowest amount.