APR Explained

How many of you heard the term APR when shopping for a mortgage? How many of you were told that APR was an important comparison tool? How many of us actually understand what APR really is and how it’s calculated?

APR stands for Actual Percentage Rate and is designed to be more comprehensive than the interest rate that is quoted by your lender. It takes into account not only the points that you paid to “buy down” the nominal interest rate, but also any additional upfront costs (such as closing costs, origination fees, etc.) that you paid to your mortgage lender. If you plug these parameters into a Mortgage APR Calculator you will be able to determine the actual interest rate that applies to your mortgage.

Here’s how APR is calculated: First, the nominal interest rate, loan amount, and loan duration are used to determine the actual monthly payment that you will be expected to remit to your lender every month. Then, the loan amount is increased by the additional upfront costs (not because these are rolled into the loan but because these are costs that need to be accounted for), and through an iterative process, the actual interest rate (aka APR) can be computed. Because your loan size has been inflated by the closing costs for the purposes of this calculation, your APR will always be higher than your interest rate.

You can use the APR to compare two loans that have different fixed interest rates and closing costs / points, but are otherwise identical. For example, if one lender quotes you an interest rate of 5% with .8 points, and another lender will offer you 5.5% with 0 points, you can perform an APR calculation to determine which loan actually offers the better interest rate.

Unfortunately, this is about the limit of the usefulness of APR. You can’t use it to compare a variable rate loan with a fixed rate loan, because the variable rate used in the calculation will in reality, fluctuate over time. In addition, you can’t use APR to compare loans of different duration (i.e. 15-year versus 30-year), since allocating the closing costs over a longer time period (30 years instead of 15 years) will automatically reduce the APR. In addition, you can’t use it to compare a loan for which you would pay the closing costs with a loan whose closing costs are paid by the lender. Finally, you can’t use it compare a cash-out refinancing with a second mortgage, because the APR calculation doesn’t take into account your existing loan.

In addition, an APR is not very useful for those with short time frames (<5 years) because the it assumes that you will hold your mortgage until maturity. If you repay (or refinance) your mortgage within a few years (instead of 15 or 30), your actual APR will be much higher than the APR that was initially calculated when you obtained the loan. That’s because closing costs and points become smaller (on a relative basis) when allocated over a longer time period.

To put it mildly, the APR has quite a few shortcomings. As I said, you can only use it to compare two loans that are identical in nearly every respect except for the interest rate and points. Don’t allow the lender to use APR as a selling tool when comparing a 30-year loan with a 15-year loan or as an argument for folding the closing costs into the loan. Still, if you understand the APR and use it wisely, it can be a good tool.