What is APR? / What is Mortgage APR?
“What is APR?” This is an explanation of Mortgage APR, to calculate APR, see Mortgage APR Calculator instead.
What is APR?
If you’ve ever wondered: “What is APR?”, “What does APR mean?”, “How does APR Work?”, “What is the difference between APR and Mortgage Interest Rate?”, then this FAQ is for you. Since “What is APR?” is a Frequently Asked Question, we thought we’d clear up some of the confusion around that ‘term’. While “Mortgage APR” isn’t an official term, Mortgage APR is different than APR’s outside of the Mortgage realm, so it is utilized to specify that the APR is applicable to home loans. Mortgage APR would be referring to the 2nd interest rate that is quoted on home loan documents. “What is APR specifically?” APR is the abbreviation for Annual Percentage Rate.
Expanding beyond ‘what is APR’, “What is Mortgage Annual Percentage Rate (What is Mortgage APR)?”
The long definition is:
Mortgage Annual Percentage Rate (Mortgage APR) is the cost of the loan expressed as a percentage, taking into account various loan charges of which interest is only one such charge.
Other charges which are used in calculation of the Annual Percentage Rate are (as applicable):
- Upfront PMI (Private Mortgage Insurance) – Conventional Loans
- FHA MIP (Mortgage Insurance Premium) – FHA Loans
- VA Funding Fee – VA Loans
- USDA Guarantee Fee – USDA Loans
- And other Prepaid Finance Charges (including, but not limited to: origination fees, loan discount fees, underwriting fees, processing fees, prepaid interest, administrative fees, lender’s title insurance, and other credit costs, etc.).
Calculating APR: APR is calculated by amortizing [spreading] these charges over the life of the loan which results in a rate generally higher than the interest rate shown on your Mortgage (also known as Deed of Trust Note in some areas). If the interest was the only Finance Charge, then the interest rate (or note rate) and the Mortgage Annual Percentage Rate (Mortgage APR) would be the same.
The short definition to: “What is APR (Annual Percentage Rate)?” is: the annualized cost of financing.
“Why is Mortgage Annual Percentage Rate (Mortgage APR) disclosed?”
Disclosing the Mortgage APR (Mortgage Annual Percentage Rate), when quoting an interest rate, is required by Truth-In-Lending (abbreviated as TIL or T-I-L) regulations.
“Why was the Mortgage Annual Percentage Rate (Mortgage APR) created?”
The reason Mortgage APR (Mortgage Annual Percentage Rate) was created is to assist consumers in comparing mortgage loan options by demonstrating the cost of financing.
“What is ‘Cost of Financing’?”
“Cost of Financing”, also known as “Financing Cost” or “Prepaid Finance Charges”, is the cost of obtaining financing.
Prepaid Finance Charges are certain charges made in connection with the loan and which must be paid upon the close of the loan. These charges are defined by the Federal Reserve Board in Regulation Z and the charges must be paid by the borrower. Finance Charge is defined as: “The amount of interest, prepaid finance charge and certain insurance premiums (if any) which the borrower will be expected to pay over the life of the loan.” Non-inclusive examples of such charges are: Loan origination fee, “Points” or Discount, Private Mortgage Insurance, FHA Mortgage Insurance or USDA Guarantee Fee, Tax Service Fee. Some loan charges are specifically excluded from the Prepaid Finance Charge such as appraisal fees and credit report fees. Prepaid Finance Charges are totaled and then subtracted from the Loan Amount (the face amount of the Deed of Trust/Mortgage Note). The net figure is the ‘Amount Financed’ as explained below.
AMOUNT FINANCED: The Amount Financed is the loan amount applied for less the prepaid finance charges. For example, if you were to apply for a loan for $200k, but that specific loan has $4k in closing costs associated with it – you basically only receive $196k for that $200k due to the $4k cost for the loan. We use that “Amount Financed” to determine the cost of financing to obtain a new rate. That “effective interest rate” is expressed as the Mortgage Annual Percentage Rate (Mortgage APR) for your home loan.
“Is the Mortgage APR (Mortgage Annual Percentage Rate) my Interest Rate?”
Your monthly payments are calculated based on your actual interest rate (also known as ‘Note Rate’). The Mortgage APR (Annual Percentage Rate) is an expression of the costs involved in financing, but do not affect your monthly mortgage payment. So despite your Interest Rate being different than your Mortgage Annual Percentage Rate, the mortgage payment remains the same.
“What are the components of the Mortgage APR (Annual Percentage Rate)?”
APR is comprised of the “Finance Charges” associated with the home loan. A simplified expression would be: Interest Rate + Finance Charges = Mortgage APR (Mortgage Annual Percentage Rate). But unfortunately, it’s not that simple.
There are a variety of costs associated with financing your home mortgage loan. We’ve included a few potential examples in the video visual, but not all the examples we included are in every home mortgage loan. Additionally, there may be other finance charges that are not included in our Annual Percentage Rate example. The finance charges are dependent on the type of loan program. A few large differences that vary with loan type are Upfront Mortgage Insurance (MI) for all FHA (and some other) loan options, which we included as an illustrative figure; and Funding Fees (for VA and USDA loans, which are not included in our example but is a finance charge on those types of loans. The stipulations on whether a fee is considered a finance charge (annual percentage rate fee) or is not considered a finance charge (APR fee) is found in Truth-in-Lending, Regulation Z, Section 226.4. We have included eight APR fees as an example in this educational video. Each of the Mortgage APR fees in our example: Upfront MI (Mortgage Insurance), Underwriting, Miscellaneous Prepaids, Wire Fee, Processing, Daily Interest Charges, Admin, and Lender Title Insurance respectively (but not all-inclusive or limited to) are added together. Those fees combined with the interest rate make up the APR.
“How do you calculate APR (Mortgage Annual Percentage Rate)?”
Short explanation: APR is calculated by amortizing the finance charges over the length of the full loan term (also known as the ‘life of the loan’).
Above is how a calculator completes the 2-step process. Let’s break it down.
First, the monthly payment is determined using the original loan amount and the actual interest rate (or note rate). Then, the finance charges are taken out of the original loan amount to remove the cost of the loan. That leaves you with the “Amount Financed”. Using your same payment, the amount is amortized over the loan term to give you the “effective interest rate”, which is the APR (Annual Percentage Rate) on the loan.
Let’s look at an example using the same numbers from earlier:
A $200,000 loan – $4,000 in finance charges with leave us with $196,000 “Amount Financed”. $200,000 with a 4% interest rate over 30 years gives us a monthly payment of $954.83. We use the “Amount Financed” along with the same monthly payment and 30 year loan term to determine the “effective interest rate” is 4.165% APR (Annual Percentage Rate).
Compare Mortgage Options:
So now that we’ve determined how the Annual Percentage Rate (APR) on a loan is calculated, let’s get into the reason the APR was designed. To compare mortgage options. Looking at a numerical example of 4% interest and $6,000 in finance charges compared to a 4.5% interest rate and no finance charges – which is the better deal?
Let’s look at a common loan option: a 30 year fixed loan. If we’re financing $200,000 with the previous examples: 4% interest + $6,000 in finance charges versus 4.375% interest with no finance charges, the 4% interest rate gives us an Annual Percentage Rate of 4.247% APR. Since there are no finance charges on the other loan option, the 4.5% interest rate is the Annual Percentage Rate. So we have 4.247% APR versus 4.5% APR. Reviewing the options that way, it’s clearer to see which offers greater savings over the 30 year loan term.
On the other hand, what if we were offered those same loan terms on a 10 year loan?
The APR increases to 4.653% versus the same 4.375%.
Now that you’ve learned “What is APR?” and reviewed the basics of Mortgage APR (Mortgage Annual Percentage Rate), be sure not to miss our related article:
“The Shocking Truth of Mortgage APR”
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