Wednesday, May 29, 2013

Why is the APR (Annual Percentage Rate) on My Loan Higher Than the Interest Rate?

You're sitting at the table in the escrow company's conference room ready to sign papers. Your real estate broker is there (usually), along with your mortgage broker (maybe sometimes) and the closing officer, who presents you with a stack of papers to sign. Among the first is a mortgage loan disclosure statement showing your interest rate at 5% and your Annual Percentage Rate (APR) at 5.13%. What's that all about, you ask.

It's difficult to explain, but in a nutshell, the APR reflects what you're paying off over the life of the loan, not just the amount you borrowed for the house. The amount you're paying off includes the amount you borrowed, plus all the closing costs. Closing costs include points and loan fees, appraisal costs, recording fees, and other charges. These usually run 1% to 3% of the loan amount.

Say your loan amount is $250,000 for the house. Lender points, appraisal charges and other fees included in closing costs are $6,250. Unless you pay those charges up front, you'll actually be borrowing $256,250, and the payment will be slightly higher than if the loan amount was a flat $250,000.

The calculation for APR is kind of complicated, but it figures out what the rate would have been for a loan with the new monthly payment amount, that is, the payment amount which includes closing costs. It's usually higher than the interest rate.

Is that clear as mud? This Zillow blog explains it in more detail.

What's the point, you say? It's a heightened Truth-in-lending legal requirement intended to disclose actual costs to the buyer. Sometimes, it can be useful to compare loans which might have different interest rates to see what their APRs are. A higher interest rate loan may actually cost the borrower less overall than the lower rate loan.

The flaw, though, is that the costs are calculated for the life of the loan. Know anyone who stayed in the same home for thirty years? Okay, there are a few, but you get the point, probably. Most people don't stay in the same house for the life of the loan, and even if they do, they usually refinance.

Still, it's a useful exercise to go through with your mortgage broker or lender, because you really can save a little dough. And if you don't have a lot of extra cash laying around, it's good to understand all this, to a degree, so you can make a good decision on how to use the cash you have available.