Lowest Mortgage Rates - Making sense of APR
If you think APR (Annual Percentage Rate) is confusing, you are certainly not alone. Even most lenders feel APR can be a confusing topic. APR is supposed to be a means by which borrowers can determine the exact cost a mortgage will be for them, and APR can allow better comparison among lenders and their mortgage products.
One of the results of the Federal Truth in Lending law was to require mortgage companies to disclose the APR when advertising a rate to borrowers. Prior to this, many fees and costs within the loan were well hidden behind what appeared to be very low mortgage rates. Requirements to disclose these fees and costs as the APR calculation allowed the true cost to be presented as an annual rate.
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Despite these disclosure requirements, there is not an actual definition of how the APR must be calculated. This again can allow for some ambiguity, but generally speaking APR does allow better realistic comparisons among mortgage products. Most calculations of APR consider the total loan amount minus all related fees, costs and points; and then this actual loan value compared to the monthly mortgage payment to yield the APR. To illustrate this, take the following example:
A mortgage lender advertises a 7.0 percent interest rate on their 15 year fixed mortgages. In order to calculate the APR, first the lender estimates the present value loan amount. This is done by taking the total loan amount (let's say $100,000) and subtracting points, closing fees, appraisal costs, origination fees, and document fees ( assume $5000). The result is the present value loan amount ($95,000). If the monthly mortgage payment is $700 a month, calculating the rate based on the total loan amount ($100,000) versus the present value loan amount ($95,000) gives a false lower rate. The present value loan amount is a more accurate reflection of the mortgage loan. The APR is based on this value rather than the total loan amount. So while the initial interest rate appears to be 7.0 percent ($700 divided by $100,000), the APR is actually 7.35 percent ($700 divided by $95,000).
By taking into account the additional costs and fees, the APR is a better reflection of the true mortgage rate. This allows you a better comparison between lenders. It does this through making sure all fees and costs are disclosed up front and this allows you, the borrower, to clearly understand the actual rate you are being charged for your mortgage. There are some situations where the APR may still fail to disclose all the known risks or costs to you. In some situations, there may be pre-payment penalties for terminating a mortgage early, or making advanced payments on the principal. If this is the case, the APR may not allow for this in its calculation. Be sure to ask what happens if you make an extra payment or if you terminate the mortgage loan early. Likewise, variable loans can make it difficult to calculate the APR for a few reasons. First, after the fixed period of time, the mortgage rate is tied usually to an index that determines the mortgage rate during the variable period. Some indices are more difficult to define than others. This can allow some room for interpretation if the index can be derived from more than one source, or if it can be calculated in different ways. Be sure this is defined well. Additionally, balloon portions of the loan can be impossible to predict up front, and therefore, the APR is stated for the term of the fixed portion of the mortgage rate; then the adjustable portion indicated by a +/- figure to indicate the range which the rate may rise or fall. An example would be 6.75 percent APR +/- 1.5 percent. This indicates that each year the APR can rise or fall 1.5 percent from the 6.75 base percent depending on the adjustable index. Overall, using the Annual Percentage Rate is the fastest way to compare apples to apples when determining different mortgage products. Because it considers the fees, points and costs, the end rate is a more accurate reflection of your mortgage rate. Watch out for additional hidden costs when making early payments and terminations, and also understand the adjustable parameters of a mortgage well. APR is a good tool for shopping and comparing mortgage rates and should be looked at along with an itemized breakdown of the lender based fees to determine the very best loan offer.
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