WHAT IS MORTGAGE APR, Can You Explain It?
APR Demystified and APR Predators Exposed
First, lets demystify Annual Percentage Rate (APR).
Mortgage APR was designed to allow consumers to use one standardized number to compare each lender's rate for the same type of loan while rate shopping. It is supposed to represent the borrower's cost and it works like this.
If I lend you, $10,000 and, I charge a $500 Bump-ta-Bump Fee, you will actually receive $9,500, however you must still repay me $10,000. Mortgage APR is my real yield and your real cost on this loan.
We agreed that you will repay the loan at 8% interest on $10,000, HOWEVER you only received $9,500 therefore I will earn more than the 8.0% interest rate I charge on $10,000. In this case, my yield (APR) is 9.799% on the $9,500 you received.
APR is the lender's yield on dollars actually lent ($10,000 minus $500 = $9,500); in this case, the lender's yield (APR) on $9,500 is 9.799% (APR is computed as if the above example is a 30 year loan)
The $9,500 also represents the Amount Financed in the Truth In Lending (TIL) disclosure.
For those of you who use spreadsheets the Rate Function will find APR. Use the Amount Financed for Loan Amount and use the monthly payment on the actual loan amount.
Fees that must be subtracted from a mortgage loan to properly calculate Amount Financed for APR
- Origination and Discount Points
- Processing and Lender Fees
- Pre-Paid Interest (Use 15 days when closing date is unknown)
- Monthly Mortgage Insurance must be added to the payment of all FHA loans and Conventional loans greater than 80% loan to value.
- The inclusion of Mi or MIP accounts for the large spread between Rate and APR on loans with mortgage insurance.
NOTES: FeesNot used in APR calculation; third party fees such as appraisal and credit. APR can only be compared on loans of the same type and amortization period
How Do APR Predators Work?
Many sophisticated borrowers shop interest rates by searching for lowest APR which, if property stated, is a valid way to compare similar loans. Unfortunately, APR is not always stated properly.
How is advertised Mortgage APR is misstated?
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Prepaid Interest is not included - most common deception and true on all online Rate sites i.e.: Bankrate.com, Interest.com, Mortgage101.com, ShopRate.com, etc.
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Prepaid Interest is understated - must be 15 days when closing date is unknown.
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MI or MIP is not included in the APR on any online rate sites, Bankrate etc.
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Some lenders do not include MI or MIP on their web sites such as Amerisave.com
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Lender fees are either understated or not included in the APR calculation. This is a tricky one because No or Low Lender Fees does not necessarily indicate a predatory lender. Some lenders charge a higher rate and no points or fees for their so called "Zero Cost" loan. However, the "Zero Cost" rate will always be higher than a rate with points and/or fees.
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Notes to the above:
- there is no such thing as a Zero Cost loan and some states prohibit lenders from advertising Zero Cost Loans.
- The spread between Rate and APR on loans greater than 90% LTV should be at least 0.700%. When it is not... you are being scammed
Rate - Points - Fees are all interdependent
The best way I can explain this is show various Rate - Point - Fee combinations where the lender is making the same gross profit on each combination.
In the examples below, we will use a $200,000 loan amount and Lender gross profit of $1,000, on a day when the Lender's cost for a 5.000% rate is par (0 point).
Best Rate: $1,000 Lender profit in various combinations of points and fees
|
Rate
|
Fees
|
Points
|
APR
|
Profit
|
|
5.000%
|
$1,000
|
0
|
5.044%
|
$1,000
|
|
5.000%
|
$500
|
0.250
|
5.044%
|
$1,000
|
|
5.000%
|
$0
|
0.500
|
5.044%
|
$1,000
|
Lowest Fees:
Increase the rate to 5.125% and you pay $0 points and fees and Lender's investor pays the lender $1,000 for the higher rate.
|
Rate
|
Fees
|
Points
|
APR
|
Profit
|
|
5.125%
|
$0
|
0
|
5.125%
|
$1,000
|
The point here is that lenders design their loans to provide talking points for their sales staff (loan officers). They all require a certain profit margin and it is not important the way the loan is structured as long as the closed loan delivers their required profit margin.
This illustration also points out the value of correctly stated APR as a way of comparing mortgage loans. For the sake of these illustrations, prepaid interest was not used. If 15 days PP was calculated it would have increased each APR by 0.019%.
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187 Comments on What is Mortgage APR, Can You Explain It?
As the others have stated, great explanation to this very confusing element in lending.
Nice write up. I always feel that folks are manipulating numbers when they talk about mortgages. It feels a little like shopping for a car.
That is pretty simple I would say, thanks for the explanation. I wonder why we have 30 years and not just 15's or 50"s how did most become 30
Well explained. Certainly one of the most difficult questions we try to answer to make a client understand.
Wow, my head is spinning, it is no wonder consumers are confused. APR is definitely something that abuyer needs to reawlly talk about with their lender. I am going to read this again and get a better grasp on it
This is a great post explaining APR. Is is very difficult to get a handle on. Thanks for this information.
Jeanne, APR is the most confusing number in lending when the original idea was to make things simple.
Joan, thanks for your comment.
Bill, this is an excellent explanation of APR. I have had some loan officers who are not able to explain APR.
I have been astounded by the lack of understnding of APR. Borrwoers do not seem to care and they chase the perceived lowest "rate"
Sharon, unfortunately many loan officers cannot explain APR. Use APR as a test when enterviewing LOs. If they cannot explain it to you they cannot explain it to their borrowers.
Paddy, unfortunately you are correct. That is why borrower education is so important.
Bill -- what a great explanation of the APR that people are supposed to be using, so by extension so many lenders are abusing. The one other thing that I usually notice on "Lowest rates" advertising is that they are limiting it to 15 years, and then requiring 70 or 80% LTV -- it would be interesting if everyone had to use the same loan amount, over the same period, with same LTV - for their example.
Steven, that is really a great idea.
That about puts it in simpliest of terms and easy to read and understand. Good Luck Bill and Happy Posting
Thanks for this explanation. I must admit I find all of this quite confusing.. if the government thought APR was going to make it easier for consumers, I think they missed the boat.
Good explanation. I have been at this a long time; nothing is as confusing to Borrowers/Buyers (and Realtors) as APR!
Bill Now you have scared the bejiggers out of me. I feel like a buyer or seller that read an article on Zillow or Trulia and now knows the market! I'm beginning to feel like an expert! Well written and thanks
Thank you for sharing a great information Bill. I enjoyed reading your post.
Hi Bill:
Informative blog. I thank you for sharing it. I need to work through some of your examples with my HP12C.
I am not sure many consumers understand the difference between interest rate and APR.
Thanks all for your comments.
Charles, thank you, a simple mind is able to state things simply.
Joan, there is a lesson here about politicians doing most things.
Fred, Kind of what I said to Joan. Politicians can even screw up a good idea.
John, thanks. The good news is that we can never know too much.
Wika, I enjoyed that you read my post.
Randy, a good man with a HP12C can rule the world.
Gary, you are correct and that causes problems for those cannot explain the difference.